Watching one of my economics channels this morning and the man pulled up a Quarterly Derivatives Report-4th Quarter 2023 that was fairly jaw-dropping; see Table 13.

Some of you guys will say it's no big deal. Personally, I don't know...it might actually be nothing. I'm not a banker. The dollar amounts were staggering to me. It looks like some of our banks are leveraged to the hilt; top to bottom. Considering the BoJ is having trouble with one of their big banks, Norinchukin and likely others as well, I'm kind of wondering if their contagion could make it's way into our banks here.

The only reason I follow stuff like this is due to getting hit hard in 2001 and 2008. It's starting to look like another one of those times where everyone's chips are going to get raked in by the house and we have to begin re-building our stack again.

Thoughts on table 13 are appreciated.

You're definitely right in intuitively being concerned about those exposure levels - I'm in the same boat. Where I get tripped up is on the valuations. I see the numbers they're giving me but the underlying model and discounted expected cash flows aren't really verified in the same way on both sides of the ledger.

When we're audited, for revenue testing, our auditors will confirm with our counterparty the validity of invoicing, pricing, terms etc. Ultimately, our +100M has to be offset by their -100M. That's a very clean assessment of value. Derivatives don't have the benefit of a clean assessment of value.

Even now as risk-free rates trend higher, those derivative valuations should be coming down on a nominal basis. To the degree that they could come down so far that groups may trigger stop loss trades, you'd have to wonder if that's contagion level or not. Once those dead hand trades actually start to happen, the market is forced to recognize a real valuation rather than the mark-to-model valuation they're using now.

It's super high leverage/margin game and it will come undone at some point.

Don't worry! Your bank deposits will bail in these guys and they'll be fine.

https://www.cnbc.com/2024/06/21/living-wills-citigroup-jpmorgan-chase-goldman-sachs-hit-by-regulators.html

BigN--00 said:

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https://www.cnbc.com/2024/06/21/living-wills-citigroup-jpmorgan-chase-goldman-sachs-hit-by-regulators.html

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"While we've made substantial progress on our transformation, we've acknowledged that we have had to accelerate our work in certain areas," the bank said. "More broadly, we continue to have confidence that Citi could be resolved without an adverse systemic impact or the need for taxpayer funds."

JPMorgan, Goldman and Bank of America declined a request to comment from CNBC.

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cgh1999 said:

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The vast majority of derivatives in community/regional banks are interest hedges. Either at the bank level, or individual loan level.

Customer does a $10 million RE loan. Bank charges a floating rate, but "SWAPS" the transaction. A counterparty bank (Goldman, wells, Chase, PNC, etc) offers a fixed rate conversion for the client.

This is good for the community bank as they can offer the client a fixed rate without the interest rate risk on their own books. If they fixed it at 7% on book when they were paying 3.5% for deposits, good. But if deposit costs go up 2%, then margins are squeezed. In a SWAP scenario, the client pays the bank the fixed rate and the counterparty bank refunds the difference between the "fixed" payment and what the client pays in a floating rate.

The real risk IMO is that the "collateral" for the SWAP is the RE. So if banks have significant RE issues, then unwinding the derivatives becomes a challenge. If it is widespread, then the counterparty banks will have bigger issues trying to unwind/collect.

They've also very likely got additional derivatives in place to hedge their exposure. But, what if their counterparty has funding issues?

TLDR - derivatives are good. And derivatives are bad.

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Derivatives are just a way of risk sharing/diversification. Not exactly banking related, but imagine loading a VLCC with 2MM barrels of oil and delivering it a month later. Good thing we have derivatives (WTI or brent contracts as an example) so you can share the risk of the cargo with the general market. Otherwise you could easily lose $20MM trying to meet market demand. Now you have a way to lock in profits.

Derivatives are almost exclusively good. You just need to understand your risk.

Gordo14 said:

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Heineken-Ashi said:

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Gordo14 said:

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TTUArmy said:

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Watching one of my economics channels this morning and the man pulled up a Quarterly Derivatives Report-4th Quarter 2023 that was fairly jaw-dropping; see Table 13.

Some of you guys will say it's no big deal. Personally, I don't know...it might actually be nothing. I'm not a banker. The dollar amounts were staggering to me. It looks like some of our banks are leveraged to the hilt; top to bottom. Considering the BoJ is having trouble with one of their big banks, Norinchukin and likely others as well, I'm kind of wondering if their contagion could make it's way into our banks here.

The only reason I follow stuff like this is due to getting hit hard in 2001 and 2008. It's starting to look like another one of those times where everyone's chips are going to get raked in by the house and we have to begin re-building our stack again.

Thoughts on table 13 are appreciated.

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Derivatives are not necessarily a scary or bad thing - just a scary word for people that don't understand trading. What matters is risk. The table does nothing to quantify risk (I did not go through the whole report). How much of it is in spreads? How much is a hedge for physical positions? How much can the instruments move? How much are fundamentally offset positions that just need to be closed? How much is actually their clients position in wealth management services?

Knowing how banks operate in the trading world, they are very risk averse and often are trading interest rates via spreads and or hedging physical positions. So the dollar size of derivatives doesn't really tell me anything.

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Derivatives are the reason for the flash crash. Don't pee on people and tell them it's raining.

And banks.. risk adverse? You trying to make me laugh. Someone hasn't done their research on banks. The fact that they needed free money from the BTFP to not tank last year is your first clue that not only are they not risk adverse, but that deposits aren't currently safe and they are hanging over a cliff.

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I trade with banks every day so I probably know a thing or two about what they do and why. They are very risk averse compared to everyone else in the market (hedge funds, trade shops, etc. Take far more proportional risk). They typically are focused on bond like returns across different asset classes which is inherently less risky than other participants.
The truth is that when you have a growing number of physical assets, you end up with more risk. Derivatives are the tool for banks to mitigate risk. So without derivatives they would have MORE risk, not less.

Derivatives are not the cause of flash crashes etc. They are just a function of people caught too long in the market which naturally must correct. Something that can happen just as much with physical assets as with derivatives.

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Risk adverse, except not.

And for clarity, it isn't just the derivatives they are NOT risk adverse with. It's everything, hence why so many of them are watching defaults rise on commercial mortgages and consumer credit, have massive rate duration mismatch that created massive liquidity concerns just a year ago (that only calmed down because of BTFP), and are having to offer savings rates at or above current treasury rates. If they didn't need you deposits, they wouldn't beg you for them.

You might trade with banks. But I'm still not sold you genuinely understand how exposed they are currently.

Reasons you shouldn't be concerned about Derivatives.

OTC Derivatives Are Presenting Huge Tail-Risk To JPMorgan | Seeking Alpha

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As the table shows, JPM had $603B in total gross derivate payables as of the end of 3Q, of which around 76% were OTC derivatives. In addition, there are tens of trillions of derivatives on the bank's off-balance sheet.

This significant risk associated with OTC derivatives was once again brought to light in March, when Credit Suisse was on the brink of collapse. As a reminder, in March, Credit Suisse published its 2022 annual report, in which it mentioned that it had identified a material weakness in its reporting procedures that could result in misstatement risks. After this report, quite a lot of large banks restricted trades with CS. Moreover, many banks reportedly stopped accepting requests to take over their derivatives contracts when CS was the counterparty. In other words, derivatives contracts, in which CS was acting as one of the counterparties, became void.

Make no mistake, an OTC-derivative counterparty default risk is not a theoretical tail-risk event, which is discussed only in academic papers. It is a real risk, and, in fact, U.S. banks are warning their clients of that risk in the SEC filings. Moreover, even tail-risk events sometimes occur. For example, such an event has recently occurred with the Fed's losses, and we discussed that in one of our articles.

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That 603B is now 533B. Better, but still a considerable counter-party risk.

Casey TableTennis said:

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Vast majority is interest rate derivatives. I believe it is a safe assumption most of that is hedging loan book to assets held. Certainly a portion is interest rate speculation and I have no clue what the ratio would be.

Behind that is foreign currency derivatives. There are numerous parties that need to hedge currencies and banks are clearly an intermediary for those. As long as the bank matches them up well, their net exposure can be non-existent.

Other derivative types are significantly minor relative to these two.

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What's the risk of .1% miscalculation on a quadrillion dollars?

Heineken-Ashi said:

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OTC Derivatives Are Presenting Huge Tail-Risk To JPMorgan | Seeking Alpha

Quote:

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As the table shows, JPM had $603B in total gross derivate payables as of the end of 3Q, of which around 76% were OTC derivatives. In addition, there are tens of trillions of derivatives on the bank's off-balance sheet.

This significant risk associated with OTC derivatives was once again brought to light in March, when Credit Suisse was on the brink of collapse. As a reminder, in March, Credit Suisse published its 2022 annual report, in which it mentioned that it had identified a material weakness in its reporting procedures that could result in misstatement risks. After this report, quite a lot of large banks restricted trades with CS. Moreover, many banks reportedly stopped accepting requests to take over their derivatives contracts when CS was the counterparty. In other words, derivatives contracts, in which CS was acting as one of the counterparties, became void.

Make no mistake, an OTC-derivative counterparty default risk is not a theoretical tail-risk event, which is discussed only in academic papers. It is a real risk, and, in fact, U.S. banks are warning their clients of that risk in the SEC filings. Moreover, even tail-risk events sometimes occur. For example, such an event has recently occurred with the Fed's losses, and we discussed that in one of our articles.

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That 603B is now 533B. Better, but still a considerable counter-party risk.

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That is also only a $40M net exposure. The degree of counter-party sick in the system is point well taken, but the gross payables is in no way indicative of risk taking from the bank. IMO, the $603B is why they, among others are in fact TBTF. They "can't" be allowed to fail, which indicates they could take risks, but it doesn't mean they are taking advantage of that status with derivatives, as is indicated by ent exposures.

jagvocate said:

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Casey TableTennis said:

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Vast majority is interest rate derivatives. I believe it is a safe assumption most of that is hedging loan book to assets held. Certainly a portion is interest rate speculation and I have no clue what the ratio would be.

Behind that is foreign currency derivatives. There are numerous parties that need to hedge currencies and banks are clearly an intermediary for those. As long as the bank matches them up well, their net exposure can be non-existent.

Other derivative types are significantly minor relative to these two.

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What's the risk of .1% miscalculation on a quadrillion dollars?

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My trusty HP 12c Platinum won't show that many digits, but I think $1 trillion if I did the mental math correctly.

Good thing the typical bank is risk averse and net derivatives to mitigate risk of that happening!

To what degree would a packaging scenario on derivatives (similar to MBS in the GFC) play a role?

While a bank can very risk averse in choosing to buy a highly liquid exchange traded derivative - could it also be true that some of the "safe" derivative plays are just packaged up junk? I'm thinking along the lines Moody and S&P rating the MBS with their eyes closed. You'd have to assume the top tier banks know what they're getting into but once you step down a level - is every risk officer as well equipped, staffed and trained as tier 1 banks?

Valuation and counter party risk is definitely an issue, would that be akin to the equity tranche in the MBS example? The tranche where cash flows could just almost drop to 0 and no-one know what happened?

I understand I am talking about a subset of derivatives and not all are as opaque as I'm implying in my question.

This video on bank's derivative exposure out just a few hours ago. Let me know if you agree or disagree with anything the interviewed gentleman discusses. As I understand, the old fellow here worked in the bond markets of England and Switzerland.

Thank you for sharing. Was an interesting watch. I was unaware of Mario, his podcast, and Elijah prior to this.

He was clearly very experienced and economically literate. Seemed to be a reliable source of facts, and was clear where he was expressing an opinion/view.

My biggest issue is that everything he said came from his view/conclusion. If someone didn't understand or know his neutral is anti-fiat, and gold/silver should be held over having "any" money in banking system, in US or foreign, it would be hard to parse his view vs other macro-economists.

Beyond his level-headed approach, I most appreciated his early point regarding the amount of derivatives there could be offshore and off-balance sheet. It is opaque, and that could be a risk of unknown scale.

The initial premise was overblown in my view. It is FDIC's job to ensure health of the banks. Since the great financial crisis balance sheets are so much stronger, tier 1 capital and ratios are much improved, etc… if those are good, additional risks should be sought and explored and the warning to review unwind procedures is prudent more than alarming to me.

I also believe there would be stimulus to stem contagion if derivatives were causing a systemic problem. A few hundred billion like TARP is cheap vs the alternative. I hate that, but it seems to be true. Even Mario believes more QE will always be the answer until eventual collapse of current systems.

A minor point, but one that jumped to me. He argued Japan has not been fighting deflation, but instead has been in an inflationary environment. The only way this is true is if you look to an outside reference point, and he used Gold. This is absolute silliness to me. They aren't pegged to a gold standard. Further, we are not in a two-asset world, fiat and precious metals. Japan's economy has benefited (in global trade as a producer) from the yen weakening and foreign investment is real. Wealth creation exists independent of what happens to a currency vs gold/silver.

My most significant theoretical argument would be his view on Glass-Steagall. I fall in the camp Glass Steagall would likely not have stopped the Great Depression nor the GFC. The events leading to both arguably were not the practices curtailed by the act. Further, he mention the repeal, but failed to mention it was really effectively replaced by GLBA. Also, more noteworthy to me, the Volker Rule was absent from his expressed views. GLBA, the Volker Rule, among other legislation, in my view are superior to addressing the risks most worry about from the "repeal of G-S". I readily note this is theoretical and highly debatable, but he left out two key pieces of the debate, conveniently two key pieces that ameliorate the strength of his argument.

Will give a little more of his content a view. Even if I disagree with chunks, he presents himself clear enough that a reasonably informed listener/viewer can stretch their mind.

I will again ask, if banks are so healthy, and FDIC so responsible, why did 2023's banking scare force the FED to go a route so creatively out of left field (BTFP), which effectively paid banks free cash, vs the traditional stimulus methods for liquidity?