Saturday, October 15, 2011

Derivatives: The $600 Trillion Time Bomb That's Set to Explode...

Derivatives: The $600 Trillion Time Bomb That's Set to Explode...

Do you want to know the real reason banks aren't lending and the PIIGS have control of the barnyard in Europe?

It's because risk in the $600 trillion derivatives market isn't evening out. To the contrary, it's growing increasingly concentrated among a select few banks, especially here in the United States.

In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to
a recent report from the Office of the Currency Comptroller.

The four banks in question: JPMorgan Chase & Co. (NYSE:
JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS).

Derivatives played a crucial role in bringing down the global economy, so you would think that the world's top policymakers would have reined these things in by now - but they haven't.

Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market.

Think I'm exaggerating?

The notional value of the world's derivatives actually is estimated at more than $600 trillion. Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments.

The world's gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.

Compounding the problem is the fact that nobody even knows if the $600 trillion figure is accurate, because specialized derivatives vehicles like the credit default swaps that are now roiling Europe remain largely unregulated and unaccounted for.


To be fair, the Bank for International Settlements (BIS) estimated the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money and well beyond the billions being talked about in Europe.

Imagine the fallout from a $600 trillion explosion if several banks went down at once. It would eclipse the collapse of
Lehman Brothers in no uncertain terms.

A governmental default would panic already anxious investors, causing a run on several major European banks in an effort to recover their deposits. That would, in turn, cause several banks to literally run out of money and declare bankruptcy.

Short-term borrowing costs would skyrocket and liquidity would evaporate. That would cause a ricochet across the Atlantic as the institutions themselves then panic and try to recover their own capital by withdrawing liquidity by any means possible.

And that's why banks are hoarding cash instead of lending it.

The major banks know there is no way they can collateralize the potential daisy chain failure that Greece represents. So they're doing everything they can to stockpile cash and keep their trading under wraps and away from public scrutiny.

What really scares me, though, is that the banks

think this is an acceptable risk because the odds of a default are allegedly smaller than one in 10,000.

But haven't we heard that before?

Although American banks have limited their exposure to Greece, they have loaned hundreds of billions of dollars to European banks and European governments that may not be capable of paying them back.

According to the Bank of International Settlements, U.S. banks have loaned only $60.5 billion to banks in Greece, Ireland, Portugal, Spain and Italy - the countries most at risk of default. But they've lent $275.8 billion to French and German banks.

And undoubtedly bet trillions on the same debt.

There are three key takeaways here:

  • There is not enough capital on hand to cover the possible losses associated with the default of a single counterparty - JPMorgan Chase & Co. (NYSE: JPM), BNP Paribas SA (PINK: BNPQY) or the National Bank of Greece (NYSE ADR: NBG) for example - let alone multiple failures.
  • That means banks with large derivatives exposure have to risk even more money to generate the incremental returns needed to cover the bets they've already made.
  • And the fact that Wall Street believes it has the risks under control practically guarantees that it doesn't.
Seems to me that the world's central bankers and politicians should be less concerned about stimulating "demand" and more concerned about fixing derivatives before this $600 trillion time bomb goes off....

Derivatives are not tangibles, but rather sales of future cash flow. Hence there are several counter-parties. Most notable and the real threat is the insurance bought to limit exposure risk. Lehman was in the insurance business of the mortgage CDO sector. When the shift, Lehman lacked the cash and access to cash to cover the settlements for loss.

Herein is the problem. If the settlement for loss can't be covered by the derivative insurer, the losses go straight to the bank's bottom line. Stock and bond-holders of the insurer are wiped out. Same for those with shares in the bank that is counting on the settlement.

Chain reaction. In and of itself, this is good. Higher risk means higher potential for profits and loss. The insurance on derivatives was meant to reduce risks and insure profits. Yah, good luck with that.

The problem is the fear factor among the depositors. They will run on the bank and wipe out what little remains on deposit. The majority of money deposited is already loaned out. In a strangled economy, the potential for default on the loans is high. Oh-ho, the deposits are insured by FDIC and the loan is insured by a counter-party already tapped out. FDIC will have to call on Treasury and Fed to roll the presses.

Fact of life, you can only pile feces so high before it falls over. The real problem is each derivative has too many counter-parties completely dependent upon each other to make good. Good luck with that.....

Bank profits are highest since before the recession…: According to the Federal Deposit Insurance Corp., bank profits in the first quarter of this year were “the best for the industry since the $36.8 billion earned in the second quarter of 2007.” JP Morgan Chase is currently pulling in record profits.

…even as the banks plan thousands of layoffs: Banks, including Bank of America, Barclays, Goldman Sachs, and Credit Suisse, are planning to lay off tens of thousands of workers.

Banks make nearly one-third of total corporate profits: The financial sector accounts for about 30 percent of total corporate profits, which is actually downfrom before the financial crisis, when they made closer to 40 percent.

Since 2008, the biggest banks have gotten bigger: Due to the failure of small competitors and mergers facilitated during the 2008 crisis, the nation’s biggest banks — including Bank of America, JP Morgan Chase, and Wells Fargo — are now bigger than they were pre-recession. Pre-crisis, the four biggest banks held 32 percent of total deposits; now they hold nearly 40 percent.

The four biggest banks issue 50 percent of mortgages and 66 percent of credit cards: Bank of America, JP Morgan Chase, Wells Fargo and Citigroup issue one out of every two mortgages and nearly two out of every three credit cards in America.

The 10 biggest banks hold 60 percent of bank assets: In the 1980s, the 10 biggest banks controlled 22 percent of total bank assets. Today, they control 60 percent.

The six biggest banks hold assets equal to 63 percent of the country’s GDP: In 1995, the six biggest banks in the country held assets equal to about 17 percent of the country’s Gross Domestic Product. Now their assets equal 63 percent of GDP.

The five biggest banks hold 95 percent of derivatives: Nearly the entire market in derivatives — the credit instruments that helped blow up some of the nation’s biggest banks as well as mega-insurer AIG — is dominated by just five firms: JP Morgan Chase, Goldman Sachs, Bank of America, Citibank, and Wells Fargo.

Banks cost households nearly $20 trillion in wealth: Almost $20 trillion in wealth was destroyed by the Great Recession, and total family wealth is still down “$12.8 trillion (in 2011 dollars) from June 2007 — its last peak.”

Big banks don’t lend to small businesses: The New Rules Project notes that the country’s 20 biggest banks “devote only 18 percent of their commercial loan portfolios to small business.”

Big banks paid 5,000 bonuses of at least $1 million in 2008: According to the New York Attorney General’s office, “nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers bonuses of more than $1 million apiece for 2008.”

In the last few decades, regulations on the biggest banks have been systematically eliminated, while those banks engineered more and more ways to both rip off customers and turn ever-more complex trading instruments into ever-higher profits. It makes perfect sense, then, that a movement calling for an economy that works for everyone would center its efforts on an industry that exemplifies the opposite....

Panic as the derivatives domino chain plays out....

1......B of A and the Fed / Treasury are at war....they will stab each other in the back until B of A is finally dismantled.

2......the rating agencies are irrelevant to the smart money.....the real market players do very extensive private due diligence and have access to information that the ratings agencies will never see. All ratings agencies are paid to give a rating that is desired by the purchaser. B of A is paying for the rating.

3......after the FCIC report came out.......rating agencies are now about 20% of the factors considered in decision sovereign and pension management funds.

4......the economic shock had nothing to do with the rating downgrade.......that was a charade...the shock came from the idiocy of our own Congress. In a fiat money system unless taxes are greater than or equal to expenses .......the deficit must continually be raised.........or the govt defaults.....end of story......the idiotic show that the congress put on scared the crap out of everyone........the downgrade was a trailing indicator not a leading indicator.

5......after the EU summit.....or sooner....the world is going to pile into treasuries as never before........,if there is another downgrade it will come way to late to stop any purchase of treasuries.

6......The US dollar is the world's reserve currency.....and will remain so until some other country becomes the absolute crown of internal demand and self reliance. EU and the BRICS are completely dependent on exports. The US needs its exports....but we can survive without them. We have one of the largest......"in production"......arable land masses in the world. We can feed our own people.

There are several more ....but this is enough to prove my point.

Anyhow, it really won't matter, because the world will change irrevocably after the EU summit...and everyone, is going to need a new plan.

So this downgrade.....if it is not just a hopeful rumor .......will be completely overshadowed by the panic as the derivatives domino chain plays out..
Borrowing costs haven't gone up because we're borrowing from our own printing presses. Combined with the Fed artificially, massively, holding down interest rates both long and short term. Just wait until this Ponzi scheme snaps in the next couple of years, borrowing costs will in fact skyrocket....

The capitalist system in America is the best in the world but it has one major flaw. It requires the integrity of each participant in order to work.

It requires that home mortgages be provided to individuals who have a proven ability to be able to pay them back.

It requires that elected officials honor the wishes of their constituents rather than selling their votes to the highest bidder.

It requires that parents raise their children with a sense of solid work ethics and morals rather than a sense of entitlement and greed.

Without core tenants such as these, which are totally absent in today's USA and the World at large...., we will watch the greatest economic system ever created collapse into ruin.....

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