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Friday, September 16, 2011

America's Big Bank $244 Trillion Derivatives Market Exposed

I have been extremely interested in the global derivatives market ever since I saw the documentary "Collapse." I am not going to bore you with the details of this documentary, but to summarize, the documentary focuses on the unsustainable global dependence on oil supply (which is decreasing), and the unsustainable nature of our current capitalistic society (topic for another day). In this documentary the main character/pundit/whistleblower, Michael Ruppert, states that the world derivatives market is in excess of $700 trillion. Needless to say I was blown away by this amount, and I vowed to do some research and figure out how there can be an active financial market 50 times that of the United States Gross Domestic Product.

I am not going to attempt to delve into the global derivatives market as a whole. Instead, I will focus on the derivatives that are written by U.S. commercial banks, talk about the various derivatives out there, and explain the amount of exposure to the United States banking system. To do this I will be using the most recent OCC report on derivatives held by commercial banks here in the U.S.

Summary of the U.S. Derivatives Market
  • U.S. commercial banks currently hold a notional value of $244 trillion in derivatives.
  • Trading exposure, which is measured by VaR (Value at Risk), is $677 million.
  • Net Current Credit Exposure of commercial banks to derivatives is $353 billion, due to bilateral netting.
  • Potential Future Exposure is $814 billion, bringing Total Credit Exposure (NCCE + PFE) to $1.2 trillion.
  • The total amount of Credit Derivatives outstanding is $14.9 trillion.
  • 30 days or more past due derivatives equaled $42 million, and $74 million in derivatives was charged off this quarter.
  • 59% of counterparties are banks and securities firms, 35% are corporations, 1% are monoline financial firms, 2% are hedge funds, and 3% are sovereign funds.
  • Banks hold collateral equal to 72% of Net Current Credit Exposure.
  • 82% of derivatives are interest rate products, 10.9% in FX contracts, 6.1% in credit derivatives, and .6% are in commodities and equity contracts, respectively.
  • Five banks dominate the U.S. derivatives market, J.P. Morgan Chase (JPM), Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and HSBC (HBC), accounting for 96% of the derivatives activity. However, a total of 1,047 U.S. banks participated in the derivatives market in the first quarter.
  • Banks reported trading revenue (revenue pertaining to derivatives) of $7.4 billion in the first quarter of 2011.
This is a lot of information to handle so I am going to delve deeper into all of the summary points, and shed some light on all of these statements.

U.S. commercial banks currently hold a notional value of $244 trillion in derivatives.


Notional value is the face amount of the derivative used to calculate payment on swaps, options, futures, and forward contracts. This is not the amount of exposure that banks have to the derivatives market. Here is a simple example: Two parties approach a bank, and they want to do an interest rate swap for a loan. One wants a fixed interest rate, while the other wants a floating interest rate. The bank acts as a clearinghouse and third party overseer for this transaction. Both parties pay a set fee (usually a spread on the interest rates) to the bank based on the amount of the loan amount they are swapping payments on, they also give their respective payments on the loan amount through the bank, and the bank sends the payment to the other party. Now if the amount of the loan that the two parties were swapping interest rates on was $1 trillion that $1 trillion would be included in the notional value of derivatives held by the banks. Another example: If a bank buys or sells (hedges risk or assumes risk) a Credit Default Swap the face amount is included in the notional value.
 
Trading exposure, which is measured by VaR (Value at Risk), is $677 million.

VaR (value at risk) is a statistical analysis performed by banks to determine the potential amount of maximum expected losses (on their trading activities) that they could sustain over a specified duration of time and under normal market conditions. Here is an example from the OCC report.

A VaR of $50 million at 99% confidence measured over one trading day, for example, indicates that a trading loss of greater than $50 million in the next day on that portfolio should occur only once in every 100 trading days under normal market condition.
Basically, the VaR is telling us that the bank is 99% confident (confidence level depends on the standard deviation used) that over the next 100 trading days it will lose a maximum of $50 million. So the total VaR of $677 million for the quarter is the maximum expected aggregate loss that banks think they could lose.

Net Current Credit Exposure of U.S. commercial banks is $353 billion, due to bilateral netting...
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