The $289 Trillion Problem
Two hundred and eighty-nine trillion dollars. An unimaginable amount. That is the total of derivatives outstanding at the top five US bank holding companies as of March 31, 2012, according to the Office of the Comptroller of the Currency (OCC).
The five holding companies are JP Morgan Chase (JPM-NYSE), Bank of America (BAC-NYSE), Citigroup (C-NYSE), Morgan Stanley (MS-NYSE) and Goldman Sachs (GS-NYSE). They hold roughly 45% of all over-the-counter derivatives outstanding in the world, based on the $648 trillion total estimated by the Bank for International Settlements. Others estimate that the total global derivatives outstanding could be as large as $1.2 quadrillion, or $1,200 trillion.
All five were recently downgraded (amongst others) by Moody's, as follows:
Bank of America: downgraded to Baa2 from Baa1;
Citigroup: to Baa2 from A3;
Goldman Sachs: to A3 from A1;
JP Morgan Chase: to A2 from Aa3;
Morgan Stanley: to Baa1 from A2.
The outlook remains negative for all five banks. All the ratings are still investment grade, but at Baa2 both Citigroup and Bank of America are now only one notch above the lowest investment grade rating of Baa3.
What the downgrade means for these banks is that they will have to post additional collateral against trades, including derivative trades held on their books. Estimates of the amounts of additional collateral are measured in the billions of dollars. The downgrades also raise their borrowing costs, and should force other financial institutions to review their credit lines to the five bank holding companies. That could result in cutbacks in credit availability.
To no one's surprise, the banks disagreed with Moody's analysis and downgrades. Others felt it was long overdue and that Moody's didn't go far enough.
The banks put out statements assuring their customers that they had sufficient liquidity and resources to service their client base. The reality is that they face higher costs and could try to pass on those costs to their customers. Their activities in the global derivatives market may well be curtailed, which may in the end hurt the market's liquidity.
The five banking behemoths are so large in the global derivatives market that they would appear to be the market. According to the OCC, their outstanding holdings constitute some 95% of the US market total of approximately $302 trillion. Over the past decade the amount of outstanding derivatives has exploded. Since the end of 2002 the outstandings of the bank holding companies have grown from $58.2 trillion to $302 trillion an increase of 419%.
The OCC chart on the next page shows the massive growth in derivatives since 1996 (although this is for insured US commercial banks and trusts, not the bank holding companies). It does not include the holdings of Morgan Stanley, whose derivative operations are largely in their uninsured bank holding company and not in the insured Morgan Stanley Bank. As well the chart does not include Goldman Sachs prior to it becoming a bank in 2008 nor Merrill Lynch before it was merged with BofA (Merrill was estimated to have a $40 trillion derivatives book). However, the growth levels are comparable for the bank holding companies.
The growth of derivatives since 2002 has gone almost parabolic, despite the drop over the past year. One thing that stands out on the chart is that the growth is a result of trading - it is not client-driven. Client-driven derivatives, classified as "End User (Non-Trading)" in the table underneath the chart, have grown far less, going from $2.1 trillion at the end of 2002 to $4.8 trillion in Q1 2012. Credit derivatives have exploded from a small $635 billion at the end of 2002 to almost $15 trillion at the end of Q1 2012, an increase of over 2,200%.
One of the prime sources of growth has been in interest rate swaps (IRS). These are the most common derivative. An IRS is defined as an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. An IRS typically exchanges a fixed interest rate payment for a floating interest rate payment. Companies use them to manage interest rate exposure.
With the vast majority of IRS on the bank holding companies classified as trading, the bank holding companies do not operate much different than a hedge fund. I was a dealer in derivatives with a major Canadian bank and later a large Canadian insurance company's trading operations during the 1980's and 1990's. The vast majority of our dealing in the IRS market was for trading purposes and not client driven. One could create a large book quickly as IRS being an off balance sheet derivative only consumed a fraction of the capital that a loan would and credit could also be granted at a much lower level than one could offer loans. The purpose of a large book of derivatives was to take advantage of arbitrage in the different markets as well as manage the inherent positions and utilize the cash market for what was known as "carry trades" where one could borrow low and buy something at a much higher interest rate.
IRS derivatives outstanding for insured US banks and trusts have grown by 326% in just over nine years, from $32.6 trillion at the end of 2002 to $139 trillion at the end of Q1 2012, according to the OCC.
The top five bank holding companies hold a combined $168.3 trillion of IRS, which is 58% of all their derivatives outstanding. Comparable figures with 2002 are not available from the OCC because GS and MS were not included amongst the bank holding companies in 2002 and Merrill Lynch was also not included as it was an independent investment dealer prior to its merger with BofA. GS converted to bank holding company status following the financial collapse of 2008 and as noted Merrill Lynch was merged with BofA.
When a bank transacts an IRS it typically hedges itself in the US Treasury market. IRS are expressed as a spread over US Treasuries. IRS holdings of banks and trusts have grown over $100 trillion since the end of 2002 but the US Treasury market has grown by only about $9.5 trillion in the same period. Of the total US debt of roughly $15.7 trillion, foreigners hold about 33%, with China the largest creditor at roughly $1.1 trillion.
Unfortunately the OCC numbers do not show the amount of US Treasuries held by the bank holding companies. An IRS portfolio is dynamic in nature and has both assets and liabilities, so IRS positions could also be offset by other IRS positions.
Growth in IRS does, however, create a demand for US Treasuries. Some contend that it creates an artificial demand that can be used to provide support for the US Treasury market.
Jim Willie is a statistical analyst in marketing research and retail forecasting and Ph.D. in statistics. His website is www.goldenjackass.com. Rob Kirby has a degree in economics from York University and worked for several years in the institutional markets in foreign exchange, money markets, government bonds and derivatives. His website is www.kirbyanalytics.com. (Rob and I were in the markets at the same time back in the 1980s and 1990s although we did not deal with each other, even as we were on opposite sides of the trade with Rob at an institutional broker while I was with a major Canadian bank). Both Jim and Rob have written numerous articles on what they see as "shenanigans" in the global derivatives markets through the 5 bank holding companies.
Morgan Stanley (MS) is a major player in the markets. With some $50 trillion of derivatives outstanding MS stands right up with there with JP Morgan, BofA, Citi and Goldman. Yet during the financial crisis of 2008 the Fed and the US Treasury were apparently trying to find a buyer for MS. It was not dissimilar to what occurred with Bear Stearns, which was taken out by JP Morgan, or Merrill Lynch, which became a part of BofA. If MS was a problem then, what does that say about its continuing to operate for the past four years?
MS has been moving its derivative operations out of the bank holding company and into its higher-rated bank unit of late. This was reported in a Reuter's story dated June 22, 2012. By shifting its derivatives operations into the bank unit MS is protecting its ability to transact in the global financial markets as the market would be dealing with the higher-rated bank unit rather than the lower-rated bank holding company. And if the derivatives are in the bank unit, losses in trading could be covered by taxpayer insurance in the event of a financial blow-up and crash. Bank depositors are covered by the Federal Deposit Insurance Corp. (FDIC), but for bank holding companies it is the shareholders who are at risk. Morgan Stanley Bank is rated A3 by Moody's, which is one notch above MS's rating of Baa1.
So, again, if the Fed and the US Treasury were trying to find a buyer for MS in 2008 and yet it was allowed to continue even as its credit situation deteriorated, how could MS grow its derivative business since then?
MS's problems have been well known since the 2008 financial crisis, yet in the six-month period from December 2010 to June 2011 its IRS derivatives book grew from $27.2 trillion to $35.2 trillion according to figures published by OCC. Rob Kirby, in an article entitled "The Greatest Hoax Ever Perpetrated on Mankind" that was posted at his website on June 15, 2012 said the "entire global banking community does not have sufficient credit lines for MS, to allow MS to grow their swap book by $8 trillion in 6 months".
Kirby questions how MS could grow its book even as it was well known that its credit situation was deteriorating, unless the counter party was a non-bank counterparty. The possible answer later.
Jim Willie asks how the US Treasury market can grow by roughly $1.5 trillion annually (US deficits, 2009-2012: $1.4 trillion; $1.3 trillion; $1.3 trillion, and a projected $1.3 trillion) while the Fed Funds rate is at 0% and the ten-year Treasury note has fallen under 2.0%. All this even as the bonds of Spain, Portugal, Greece and others soar to 6%, 7% or higher (US Treasury Market Teetering Tower of Babel, Fed Stuck at 0% Forever - www.marketoracle.co.uk/article34819.html May 24, 2012).
The US Treasury, with $15.7 trillion in debt and adding to it by at least $1 trillion every year, cannot afford to have interest rates rise as that could be quite devastating to the US Treasury and to the US economy. Yet for the past few years interest rates have fallen even as the need for the US to finance its deficits grew larger.
China has not added any US Treasury holdings in the past year; its holdings have even gone down somewhat. Overall foreign holdings of Treasury securities have gone up by roughly $600 billion in the past year. So foreigners are still buying US debt but at a slower pace.
The US debt-to-GDP ratio is now just over 100%. Japan's is well over 200%. The difference, however, is that Japan can count on a very large savings pool and a trade and current account surplus to finance its debt internally. The US has a dwindling savings pool and a trade and current account deficit. Japan does not depend on foreigners buying its debt. The US does, as it cannot generate sufficient funds domestically to finance its growing debt load.
So if foreigners are pulling back, who is buying? Well, the Fed has been buying quite a bit of the new issues. And as Kirby has contended, the US could be using the IRS market to generate purchases.
Here is how it would work. A non-bank counterparty (not corporate) calls the bank dealer and asks where do you pay in ten years for an IRS. The dealer quotes him and the non-bank counterparty says done. Except the non-bank counterparty does not sell the bank dealer the bonds to hedge the bank dealer's position. The bank dealer then has to go into the US Treasury market and purchase the bonds. Do this enough and the demand for US Treasuries rises. This pushes up the price of US Treasuries and interest rate yields fall, as prices move inversely to yields.
Could this explain how, not long after US Treasury bonds were downgraded by S&P, the US Treasury market rallied? Could it partly explain why interest rates fell during the euro crisis?
The explanation given by the financial pundits is that it was a flight to safety. But how can it be a flight to safety when the US has the largest debt ever created, has been downgraded, is on credit watch with a negative outlook, offers rates below the rate of inflation, and has many foreign buyers backing away from US Treasuries? It is a mystery.
The assumption is that the US will pay them back. Any other entity with $15.7 trillion of debt, growing by over $1 trillion a year, would never be able to repay it. But the US dollar is the world's reserve currency and they can monetize the debt.
Monetizing debt is just another way of defaulting. China understands this and that is why China is cutting back on its holdings of US Treasury debt and is now in the process of challenging the US$ as the world's reserve currency. China has questioned why the US$ is still the world's reserve currency when the US runs budget deficits of over $1 trillion every year and also runs trade deficits of over $500 billion every year.
There is a long history of reserve currencies changing. The world has moved from the Greek silver drachma to the Roman silver denarius to the Roman gold solidus to the Byzantine gold solidus and the Islamic gold dinar to the Florentine gold Fiorina and the Venetian gold ducat to the Dutch silver gulden to the Spanish silver dollar to the British gold pound and finally to a gold-backed US$ and then to a fiat US$ -- the only fiat currency to be a reserve currency in all of history.
Yet all of the previous ones in both gold and silver eventually disappeared. What chance does a paper currency stand?
Back to the mystery non-bank counterparty. Kirby suggests that it could be Exchange Stabilization Fund (ESF). The ESF's nickname is the "plunge protection team". It is an emergency reserve fund of the US Treasury Department that has normally been associated with foreign exchange intervention. It came into being as a part of the Gold Reserve Act of 1934. Its original funding came from $2 billion of paper profit the US government realized from raising the price of gold from $20.67 an ounce to $35, and the gold that was confiscated immediately before that upwards revaluation in the price of gold (and by turn a devaluation of the US$).
Under a 1970 Act the ESF is authorized by the President for the Secretary of the Treasury to use its money to deal in gold, foreign exchange and any other instrument of credit and securities. At the height of the 2008 financial crisis $50 billion came from the ESF to shore up money market funds. The ESF holds Special Drawing Rights received from the International Monetary Fund. The ESF has also been used to shore up foreign governments.
The ESF is part of the US Treasury but it does not publish financial statements. It appears to be accountable to no one except the US Treasury and it operates usually in secret with little or no oversight. Kirby has suggested that all of the activity with MS might be an attempt to recapitalize the company and at the same time help control the long end of the US Treasury curve. The ESF would probably not be concerned about the credit rating of MS, as would other financial or non-financial entities.
Is all this possible? Kirby goes on to point out that former US President George W. Bush bestowed upon his intelligence czar John Negroponte broad authority in the name of national security to excuse publicly-traded companies from their usual accounting and securities disclosure obligations. Notice came in the Federal Register dated May 5, 2006. The notice was paid scant attention to.
Specifically what was amended was under section 13 (b) (3) (A) of the Securities Act of 1934. The amended version says "with respect to the matters concerning the national security of the United States, the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations. These obligations include keeping accurate "books, records, and accounts" and maintaining "a system of internal accounting controls sufficient" to ensure the propriety of financial transactions and the preparation of financial statements in compliance with "generally accepted accounting principles."
Some have suggested that the financial institutions as a result of this amendment could potentially maintain two sets of books.
JP Morgan recently reported a $2 billion trading loss that was apparently tied to Credit Default Swaps (CDS) but may instead have been related to IRS. The $2 billion loss soon became $5 billion and some have said it could go as high as $30 billion. Some contend that JPM could even be bankrupt. Could something be amiss at the five US banking behemoths when poor credit risks such as MS continue to operate as if nothing has happened and JPM reports a loss and it gets brushed off?
Certainly they are highly leveraged to the market through their derivatives trading. The chart below, also from the OCC, shows the percentage of total credit exposure to risk-based capital for the top four insured US commercial banks: JPM, BofA, Goldman and Citi. On average they are at risk for 331% of their risk-based capital through derivative holdings. Of course one says the entire portfolio would have to blow up.
But it also suggests that even a blow-up on the scale of 2008 could quickly jeopardize these banks capital in the billions of dollars, if not their entire capital. And of course depositors are covered by the FDIC. But the FDIC itself was effectively bankrupted by the large number of banks that failed during and after the financial crisis of 2008. As a result the FDIC has been surviving on its credit lines with the US Treasury. Ultimately the US Treasury would have to step in to protect depositors by recapitalizing the failed banks.
Jamie Dimon, the CEO of JP Morgan, recently appeared before the Senate Banking Committee to explain the trading loss at JPM. Many pundits believe Dimon was treated with "kid gloves" by the Senate committee and the hard questions were not asked.
Dimon has been one of the strongest opponents of the so-called "Volcker Rule" that would curtail bank trading. He has been a leader in blocking attempts to re-regulate the banking industry, including possibly bringing back Glass-Steagall. That is understandable as bringing back Glass-Steagall would break up the banking giants and separate once again true banking operations from securities dealing. That is how it was before Glass-Steagall was repealed by the Clinton administration, after existing since the Banking Act of 1933.
So, in summary: according to the OCC, the big five have $289 trillion of derivatives on their books. The four that we know about are exposed at a rate of 331% to their risk-based capital. The US national debt is growing at over $1 trillion a year. It has become almost essential to maintain low interest rates as even a modest rise could cost the US government billions of dollars more in interest payments and it could jeopardize the trading books of the bank holding companies IRS portfolios.
Right now the big five are borrowing from the Fed at 0% and in the short term money markets at rates well under 0.5%. They are buying US Treasuries well above 1% in the 10 year and beyond. They know the Fed Funds rate is fixed at 0% (officially it is stated as 0-0.25%) until 2014 as Fed Chairman Ben Bernanke has said so. It is the ultimate in carry trades. Their derivative portfolios could be at risk if interest rates were to rise even a little bit. Could that be the reason interest rates keep falling as the IRS market is being used to help push down interest rates? But what if the game suddenly came to an end because of an event beyond their control? Then what? It is a $289 trillion problem.
Below are a couple of charts on US interest rates. The first one shows in price the steady rise of the long US Treasury bond futures since the lows of 1981. It has been a three decade run to the upside with no clear signs yet of topping out of US bond prices.
The second chart shows the 30 year Treasury yield dating from 1800. This is fascinating as it shows the long term cycles in play. Long term declines in interest rate yields do take place. There was a long run to the downside from roughly 1870 to 1900 also a period of roughly 30 years. Interest rate yields peaked around 1920 and fell throughout the Great Depression and war bottoming around 1945 a period of at least 25 years.
The long term cycles appear to run about 25 to 30 years from peak to trough for long term bond yields. This suggests that the current cycle could be topping out. What then for the $289 trillion of derivatives held by the big 5 bank holding companies? It is a problem.