reposted from pebblewriter.com:
In April 2012,
I calculated the size of banks' derivatives positions relative to their
capital to show how small an upset it would take in the derivatives
market to wipe out banks' Tier 1 capital.
The results were pretty
alarming. It would take only a 0.18% decline in the value of their
collective $240 trillion derivatives portfolio to wipe out their Tier 1
capital.
S&P's
announcement this evening that it had placed big US banks on Ratings
Downgrade Watch got me to thinking. Have banks improved their financial
stability, or are they still perched on the eve of destruction?
First,
it should be noted that it isn't that easy to find Tier 1 capital
anymore. The OCC now reports Total Risk-Based Capital, which includes
Tier 2 items such as subordinated debt, asset revaluation reserves,
undisclosed reserves and hybrid (debt/equity) capital instruments.
The
upshot is that Total Risk-Based Capital is bigger than Tier 1 alone
(from 5-18% bigger.) Regardless of whether or not the padding is
warranted, we'll ignore it for comparison purposes.
The 2015Q2 results can be seen in the chart below. Things have improved, but only slightly.
JP
Morgan and Bank of America significantly decreased the size of their
reported (nominal) derivatives portfolios. And, each has roughly
doubled their Wipeout Ratio.
Citibank and Goldman Sachs, on the
other hand, barely decreased the size of their derivatives portfolios.
And, their Tier 1 Capital increased only slightly. So, their Wipeout
Ratios improved marginally.
The fact remains that, seven years
after the financial crisis, the four largest banks are still extremely
vulnerable to a fluctuation in the value of their derivatives.
Theoretically, a 1/4 of 1% decline in the value of their derivatives
would wipe out their capital.
Fortunately for them and their
shareholders, the regulators don't require them to mark derivatives to
market anymore. They're also able to net out (supposedly) offsetting
positions without providing much, if any, proof that such offsetting is
appropriate. From JP Morgan's financial statements:
U.S.
GAAP permits entities to present derivative receivables and derivative
payables with the same counterparty and the related cash collateral
receivables and payables on a net basis on the balance sheet when a
legally enforceable master netting agreement exists.
In
other words, if you have an agreement with the next Bear Stearns, AIG
or Lehman wherein you promise to make each other whole when TSHTF,
there's no need to burden us with all the details. It's enough to say
that there's no net exposure.
If any of these deceptions helps you
sleep at night, God bless. The banks will gladly hold even more of
your money and pay you next to nothing. Or,
maybe they'll start charging you for the privilege, as in parts of the eurozone.
Bottom
line, S&P is probably making a big deal out of nothing. Though
global derivatives still exceed $1 quadrillion (that's 1,000 trillion or
$1,000,000,000,000,000) and the capital of the biggest, strongest banks
in the world are 0.25% away from being wiped out, there's really
nothing to worry about.
*
* until there is
* * * * *
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