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Sunday, April 1, 2012

The Wipeout Ratio

A simple calculation comparing major banks' derivatives positions to their assets and capital shows how little it would take to wipe out either.  The first ratio is the multiple that derivatives represent of Tier 1 capital.  The second shows the miniscule percentage decline in the value of derivatives portfolio it would take to completely wipe out Tier 1 capital.

Goldman Sachs, for instance, has $47 trillion in derivatives exposure -- 2,480 times its Tier 1 capital.  A 0.04% decline in the value of the derivatives portfolio would wipe out Tier 1 capital altogether.

Overall, a 0.18% decline would do the entire bunch in.    Something to think about, especially as the vast majority of derivatives are OTC, are not priced in public markets, and are obscured/netted out in balance sheets.  Remember, "too big to fail" really means "subject to taxpayer bailout."

A little over a week ago in a Zerohedge article we learned that Italy's previously hidden derivatives exposure amounted to 11% of the country's GDP.    A recent $3.4 billion payment to Morgan Stanley to settle a 1994 contract wiped out half the value of the tax hikes recently imposed on an already crumbling economy.

If this doesn't seem terribly important, consider that the derivatives exposure of the five banks above alone, at $240 trillion, is four times the combined GDP of every country on earth.  JPM, by itself, has notional derivatives exposure that exceeds the combined global GDP.

I fear this is the story of the year, folks.  And, it's just not starting to get some press.  As we learned with AIG, if one segment of the financial markets suffers unanticipated losses, the entire house of cards can come crashing down.  Banks know how bad the situation is; how else to explain the lack of interbank lending -- particularly in the euro zone?

Stay tuned.


  1. Thanks PW.  If derivatives are so harmful, why those big banks are still keeping them?    As you cited the example with Goldman Sachs, "a 0.04% decline in the value of the derivatives portfolio would wipe out Tier 1 capital altogether."   Is it because the  derivatives are so huge that they can't be reduced?

  2. To greatly oversimplify, they keep them because they can be enormously profitable or they can hedge a profitable position which, if things went south, might become unprofitable.  The problem is that banks have a poor track record lately of understanding and positioning themselves to use them wisely.

    A little mistake can turn into losses in the billions.  And with leverage that extreme, it wouldn't take much to bring one of these banks to its knees.

    The credit derivatives on mortgages a few years ago are a great example.  Again, to oversimplify, folks like AIG saw insuring against defaults as a very low risk way to rake in extra income.  Investors liked the idea of an insurance umbrella that would protect them from credit risk and issuers saw an opportunity to slice and dice a portfolio more profitably.

    It worked great, except: (1) the underlying risk was vastly greater than most anticipated, and (2) the leverage and rehypothecation was so extreme that once the crack appeared, things unraveled dramatically. 

    It's been around for a while, but I highly recommend getting a copy of Michael Lewis's Big Short.  You'll learn a lot about how Wall Street works.

  3. Thanks!   I read Michael Lewis's Big Short (library's copy) a while ago, but it was a quick read.
    It seems like I need to read it again to fully appreciate it.  What I remember most from the book was 2 person who had strong conviction on their believes that housing market would crash and they dared to bet 100% and 120% against the market.    Also, people who no income could get loans to buy a house.    A nanny of fund manager managed to own 8 apartments during the housing market. 

  4. In addition to what PW said, banks sell the derivatives in a big "circle-jerk".  They then net them out and claim to have negligible net exposure.  Which is just peachy, until one of the players in the circle doesn't have the money to cover a payout on derivatives they've sold.  Suddenly, gross exposure, rather than net, becomes an issue.

  5. wouldn't it be more usefull to know which percentage of their total position are the derivatives hedging? If the market exposure of these banks is much larger than their exposure in derivatives, would it hurt the banks so much as you expect?

  6.  It would be much more useful. Unfortunately, the banks aren't required to tell us.  From p. 114 Goldman's 2010 annual report:  "Derivatives are accounted for at fair value, net of cash collateral received or posted under credit support agreements.  Derivatives are reported on a net-by-counterparty basis when a legal right of setoff exists under an enforceable netting agreement.  Derivative assets and liabilities are included in "Financial instruments owned, at fair value" and "Financial instruments sold, but not yet purchased, at fair value" respectively. 

    The problem, then, is that everything is netted out, allowing $47 trillion in nominal gross exposure to be reported as $73 billion.  Is the netting accurate, or might there be some problems hidden in there?  And, since they're almost all OTC, who decides what fair value is?  In the credit default swap debacle, everyone reported happy slappy numbers even as the market was tanking.  They used assumptions that just weren't true, and no one called them on it until it was too late. 

    The problem is an abject lack of transparency.  Given the astounding leverage involved, a miniscule error (or deliberate misstatement) in assumptions/pricing/netting could well mean your favorite bank has no capital.