Derivatives – a ticking “systemic event”

We touched on derivatives on Tuesday talking about the unknown consequences of a Greek default (which despite some positive press this week certainly aint over folks…).

The last BIS update on total outstanding derivatives stood at an incredible $630 trillion.  $505 trillion of those are interest rate contracts.

The discourse below from London’s Ben Wright for The Telegraph is a neat summary but it was written before the Greek default looked likely.  Just for a little context first, the world’s largest derivative exposure is held by none other than Germany’s Deutsche Bank with around Eur55 trillion compared to their Eur1.6 trillion balance sheet and the entire GDP of the Eurozone being less than Eur10 trillion… 

For further context, this week the manager of one of Britain’s biggest bond funds, Ian Spreadbury, of the £4bn Fidelity fund warned that a “systemic event” could trigger another financial crisis.  He told the Telegraph Money “Systemic risk is in the system and as an investor you have to be aware of that,” and suggested the best strategy to deal with this was to spread your money widely into different assets, including gold and silver.

So on the topic of a “systemic event” over to Mr Wright on derivatives..

“…, the arguments employed by the derivatives industry sometimes sound similar to those employed by the pro-gun lobby: derivatives aren’t dangerous, it’s the people using them that you need to worry about. That’s not hugely reassuring.

What could go wrong? Let’s say that US interest rates do rise sooner and faster than the market expects. That means bond prices, which always move in the opposite direction to yields, will plummet. US Treasury bonds are like a mountain guide to which most other global securities are roped - if they fall, they take everything else with them.

Who will get hurt? Everyone. But it’ll likely be the world’s banks, where even little mistakes can create big problems, that suffer the most pain. The European Banking Authority estimates that the average large European lender still has 27 times more assets than it does equity. This means that if the stuff on their balance sheets (including bonds and other securities priced off Treasury yields) turns out to be worth just 3.7% less than was assumed, it will be time to order in the pizzas for late night discussions about bail-outs.

Barclays has predicted that if the yields on 10-year Treasury bonds reverted back to their historical average it would wipe nearly a fifth off the tangible book value of European banks. Yes, a fifth.

This is what is meant by interest rate risk. It’s big and it’s real and the banks know all about it. Their answer is to hedge the risk with interest rate derivatives. It’s one of the reasons why there are so many of these contracts in existence. So that’s all OK then.

Just one question though: who have they bought those derivatives from? Why, other banks of course. This creates what is known as counterparty risk. Bank A sells insurance to Bank B. But then Bank A gets into financial difficulties (a significant deterioration in their creditworthiness would be enough) and suddenly Bank B isn’t as well protected as it thought it was.

Indeed, Bank A might start struggling precisely because of the insurance it has sold to Bank B. What if it can’t honour the contract? This creates a potential Catch-22 situation: the derivatives work as long as they’re not needed; calling them into action renders them useless.

This is precisely the kind of thing that occurred during the credit crunch - banks stopped trusting each other. New rules introduced since then require banks to actively manage their counterparty risk. In other words, banks are being asked to hedge their hedges. From whom are they buying the derivatives to do that? From other banks of course. Are you starting to feel uneasy yet?”

We pass on these facts to illustrate the basis behind the oft quoted philosophy of ‘better to buy gold/silver a year too early than a day too late’ because derivatives are just one of many lurking dangers in this over stimulated financial system that could snap without warning and with immediate and dire consequences.  When the $294t of financial assets flock to the $1.5t gold market, the price might be the least of your worries… you just may not get it.