The following article was posted on
Seeking Alpha and is reproduced here.
Investors buy derivatives for one of two purposes: either they're speculating about the performance of the market in the future, or they're hedging against the possibility of a loss. The way in which you intend to use derivatives influences your derivative investment strategy.
If you're hedging, you'd buy derivatives as a kind of insurance policy. By having derivatives in place for a nominal fee, you can be certain of buying or selling at a certain price, and you don't have to worry as much about fluctuations in the market. Many corporations use derivatives to hedge against fluctuations in interest rates, foreign-currency exchange or the cost of raw materials.
Speculation is a different side of dealing in derivatives. Investors who engage in derivative speculation have no real interest in the underlying commodities, but instead are trying to predict the behavior of the stock market to make a profit. Unfortunately, derivatives can be manipulated in ways that make speculation dangerous to the economy. The government has some regulations in place to protect against speculative manipulation of the market, such as prohibitions against naked short selling, but it can still be a dangerous practice for the economy.
Recall that Warren Buffet once famously called derivatives "financial weapons of mass destruction" and the sovereign debt problem risks detonating these time bombs.
How big is America's exposure to these "weapons of mass destruction"?
Here is what Seeking Alpha had to say...
Details Of The $291 Trillion In Derivatives To Which American Taxpayers Are Exposed
The entire US GDP is less than $15 trillion each year. The gross notional amount of derivatives issued in the USA is more than $291 trillion. Does that sound like a lot? Apologists for derivatives dealers don't like it when we talk about derivatives in terms of the notional totals. Large numbers, like these, discussed publicly, frighten too many people. According to the apologists, gross "notional" is misleading, because it does not include "hedges," offsets and the limits on interest rate risk.
In fact, the total amount of derivatives cannot be accurately presented in any other form but gross notional obligations. The risk to society cannot be judged in any other way. That's why the FDIC, US Comptroller of the Currency and the Bank for International Settlement (
BIS) all use gross notional.
Final net obligations can only be determined when and if derivatives are triggered. The net can be significantly lower, but neither we, nor the banks themselves actually know exactly what that is. It depends upon the balance sheets of every counter-party, and the extent to which interest rates will change in the future. Not even the banks have full information about either topic..
There is another number called the "net current credit exposure" (NCCE) that some erroneously claim represents the risk imposed by derivatives. According to the Office of the Comptroller of the Currency (
OCC), the NCCE for American bank derivatives amounts to about $370 billion. That's a huge amount of money, but it's not $291 trillion.
Unfortunately, NCCE provides no information about ultimate exposure to loss. It merely measures the net cost of unwinding the contracts, before the occurrence of any trigger event. NCCE is the current market value of the contracts, and nothing more.
There are also a number of "value at risk" calculations that the banks provide. These are not standardized, and are based upon vastly different models and assumptions, from bank to bank. Unfortunately, a very high level of inconsistency and lack of any standards for measurement causes such models to be highly unreliable. For example, during the 2008 credit crisis, similar proprietary models used to determine subprime credit risk failed, in the infinitely smaller subprime mortgage market.
In reality, it is impossible to know the true risk of $291 trillion in New York issued derivatives (ignoring the additional $417 trillion issued out of London). A sudden very large increase in interest rates, alone, could trigger trillions of dollars in payments. One could argue that the Federal Reserve could force interest rates down at any time, but that is not entirely true.
If the US dollar came under heavy selling pressure, for an extended period of time, as has happened to the British pound, Chinese yuan, Japanese yen, German mark, Austrian shilling, Argentine peso, and a host of other currencies in the course of history, the Fed would be able to defend the dollar only at the risk of inducing widespread systemic failure.
That is why interest rates cannot rise for many years, regardless of whether that destroys its status as the world's reserve currency, and/or creates extreme levels of inflation or hyperinflation. It is also one more reason for the government to lie about the true inflation rate, to avoid pressure to raise interest rates (see shadowstats.com.) All the too-big-to-fail (TBTF) banks, with the exception of Morgan Stanley (which uses its SIPC-insured division) are using FDIC-insured depository divisions to house derivatives. That provides them with lower collateral requirements because FDIC depositary units usually have higher credit ratings than investment banks and/or bank holding companies. It also means that, ultimately, the American people will pay for losses.
While no one can determine the exact exposure, it is safe to say is that the risk is astronomical, and imposes a grave risk upon American taxpayers. It is not surprising that
FDIC staff is not thrilled with US bank derivative exposures. In fact, Sheila Bair, who until recently ran the FDIC, is as disgusted with the Federal Reserve slush fund and the banking cartel as you and I. A few days ago,
she penned a satirical article heavily critical of Fed policy and published it in the
Washington Post.
The FDIC staff doesn't like the fact that the Federal Reserve keeps allowing banks to put their derivatives inside insured depositary institutions. This is mostly for the same reason the banks want to put them there. Insolvency laws provides priority to derivatives counter-parties over the FDIC. If and when a bank is liquidated, the FDIC will be on the hook to repay depositors, but the failing bank will be stripped of all assets.
The US government's full faith and credit guaranty means massive amounts of new US Treasuries will need to be sold, massive numbers of new counterfeit dollars will need to be printed under color of law, and significant tax hikes will need to be levied to pay the bill.
FDIC opposition, however, has had little to no effect on keeping derivatives out of insured units. The Federal Reserve, and not the FDIC, has the authority to approve the practice and it keeps doing so. The FDIC staff can complain privately, and issue regulations forcing disclosures, but little more. But, because of the disclosure requirements, more detailed information than ever is now available concerning derivatives.
In fact, FDIC has made far more information about derivatives public, over the last 3 years, than the Fed and OCC ever disclosed over decades. The numbers reveal a frightening concentration of risk.
Five large "TBTF" US banks hold 96% of derivatives issued in the United States.
But the Bank for International Settlements in Switzerland reports that about $707.6 trillion worth of derivative obligations have been issued worldwide as of the end of 2011. That leaves about $417 trillion worth of derivatives that are not accounted for, in the FDIC records.
The surplus derivatives have been written mostly in London. Part of the exposure is held on the balance sheets of foreign, mostly European banks, including Deutsche Bank, PNB Paribas, Credit Suisse, UBS et. al. But, a large number of seemingly foreign derivatives is also hidden inside bank divisions, owned by American institutions, who do business in London. Such derivatives are not reported to the Fed, the OCC or the FDIC. Lenient British banking laws insure that these opaque obligations are not subject to public scrutiny.
Ultimately, if London-issued derivatives eventually cause massive losses to a UK bank division, the US based bank that owns it would end up being closed or bailed out. Ultimately, just like the derivatives issued in New York, the American taxpayer and dollar-denominated saver will pay the bill. Unfortunately, in spite of this, details about London-issued derivatives are not publicly disclosed or I cannot find them. If such data exists, a British lawyer or someone knowledgeable enough about UK regulations and bureaucracy would be needed to ferret it out.
Even in the absence of London data, however, investors should find this incomplete article enlightening. It is useful to obtain a general picture of the risk of investing in shares of the five big derivatives dealers. Here's how the dollar amounts break down, as of December 31, 2011 in thousands of dollars.
| Description | Amount |
| Total Derivatives | 70,268,515,451 |
| Notional amount of credit derivatives: | 5,775,740,000 |
| Bank is guarantor | 2,920,886,000 |
| Bank is beneficiary | 2,854,854,000 |
| Interest rate contracts | 53,708,319,000 |
| Notional value of interest rate swaps | 38,805,453,000 |
| Futures and forward contracts | 7,033,041,000 |
| Written option contracts | 3,841,178,000 |
| Purchased option contracts | 4,028,647,000 |
| Foreign exchange rate contracts | 8,799,397,451 |
| Notional value of exchange swaps | 2,934,191,451 |
| Commitments to purchase foreign currencies & U.S. Dollar exchange | 4,521,035,000 |
| Spot foreign exchange rate contracts | 116,741,000 |
| Written option contracts | 674,276,000 |
| Purchased option contracts | 669,895,000 |
| Contracts on other commodities and equities | 1,985,059,000 |
| Notional value of swaps | 453,521,000 |
| Futures and forward contracts | 137,101,000 |
| Written option contracts | 746,259,000 |
| Purchased option contracts | 648,178,000 |
It should be pointed out that BAC has recently moved a nominal value of about $22 trillion worth of derivatives from Merrill Lynch, into its FDIC insured division. This does not appear to be showing up, yet, in these numbers. The total for BAC's FDIC insured division is now closer to $72 trillion.
| Derivatives | 50,407,550,785 |
| Notional amount of credit derivatives: | 4,720,320,266 |
| Bank is guarantor | 2,342,544,257 |
| Bank is beneficiary | 2,377,776,009 |
| Interest rate contracts | 40,832,704,946 |
| Notional value of interest rate swaps | 29,707,570,138 |
| Futures and forward contracts | 8,203,345,962 |
| Written option contracts | 1,430,677,395 |
| Purchased option contracts | 1,491,111,451 |
| Foreign exchange rate contracts | 4,676,887,004 |
| Notional value of exchange swaps | 1,425,870,031 |
| Commitments to purchase foreign currencies & U.S. Dollar exchange | 2,839,430,866 |
| Spot foreign exchange rate contracts | 254,990,960 |
| Written option contracts | 204,427,019 |
| Purchased option contracts | 207,159,088 |
| Contracts on other commodities and equities | 177,638,569 |
| Notional value of swaps | 76,992,166 |
| Futures and forward contracts | 343,077 |
| Written option contracts | 44,438,807 |
| Purchased option contracts | 55,864,519 |
Derivatives | 52,620,696,000 |
| Notional amount of credit derivatives: | 2,975,096,000 |
| Bank is guarantor | 1,439,748,000 |
| Bank is beneficiary | 1,535,348,000 |
| Interest rate contracts | 42,568,376,000 |
| Notional value of interest rate swaps | 31,525,209,000 |
| Futures and forward contracts | 3,279,189,000 |
| Written option contracts | 3,842,701,000 |
| Purchased option contracts | 3,921,277,000 |
| Foreign exchange rate contracts | 6,488,019,000 |
| Notional value of exchange swaps | 1,349,909,000 |
| Commitments to purchase foreign currencies & U.S. Dollar exchange | 3,910,599,000 |
| Spot foreign exchange rate contracts | 518,436,000 |
| Written option contracts | 601,793,000 |
| Purchased option contracts | 625,718,000 |
| Contracts on other commodities and equities | 589,205,000 |
| Notional value of swaps | 116,124,000 |
| Futures and forward contracts | 36,180,000 |
| Written option contracts | 215,205,000 |
| Purchased option contracts | 221,696,000 |
| Derivatives | 44,195,386,000 |
| Notional amount of credit derivatives: | 499,741,000 |
| Bank is guarantor | 203,723,000 |
| Bank is beneficiary | 296,018,000 |
| Interest rate contracts | 41,737,737,000 |
| Notional value of interest rate swaps | 29,901,018,000 |
| Futures and forward contracts | 4,361,219,000 |
| Written option contracts | 3,553,371,000 |
| Purchased option contracts | 3,922,129,000 |
| Foreign exchange rate contracts | 1,945,805,000 |
| Notional value of exchange swaps | 1,623,260,000 |
| Commitments to purchase foreign currencies & U.S. Dollar exchange | 134,300,000 |
| Spot foreign exchange rate contracts | 2,912,000 |
| Written option contracts | 89,612,000 |
| Purchased option contracts | 98,633,000 |
| Contracts on other commodities and equities | 12,103,000 |
| Notional value of swaps | 11,885,000 |
| Futures and forward contracts | 0 |
| Written option contracts | 111,000 |
| Purchased option contracts | 107,000 |
According to the US Comptroller of the Currency, the Morgan Stanley holding company has about $52 trillion worth of derivatives obligations, but only $1.7 trillion show up in the detailed FDIC statistics. It is not worth listing that small fraction as it would give an incomplete and misleading picture. Unlike other banks, MS is storing most of its derivatives in its SIPC insured investment bank, rather than its FDIC insured commercial banking division.
The reason it is doing that are unclear. Unlike the FDIC, which opposed the addition of $22 trillion in Merrill Lynch obligations to FDIC insured Bank of America's balance sheet, diligent search indicates that the SIPC does not bother keeping track of derivatives. If we did have details on the MS derivatives, the company would rank number 3, slightly above Citigroup.
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