The Derivatives Bogey is Back

Part of the stress we spoke of yesterday around the spiking LIBOR rates is around the derivatives space.  The Financial Times this week reported that US bank derivatives books are now larger than at the onset of the GFC.  What few realise is that for as bad as the GFC was, it was about to get a whole lot worse with a multi trillion dollar pile of CDS (credit default swap) derivatives close to blowing up.

Bear Stearns was one of the root triggers of the whole GFC mess.  In its last annual report in January 2008 it revealed a notional value of its derivatives book of $13.4 t and warned if it saw a 2-notch ratings downgrade that would mean it would have to cough up $353m in collateral.  Whilst its mortgage book was the main trigger for its collapse as the property market tanked [Aussie banks take note], the derivatives were the elephant in the room.  And right on cue Moody’s announced a 2-notch downgrade after its shares went from $62 to $30 in 4 days and then to just $2 on that downgrade.

Their derivatives book was a mix of swaps (like CDS’s), futures, forwards and options.  Whilst banks will always argue the notional value is not their real exposure, that critically and fundamentally assumes the counterparty is good for their end of the bargain.  A derivative by definition involves 2 parties, they are normally a 2 way bet.  Credit-default swaps for example are derivatives used by hedge funds, banks and institutional investors to protect against losses or to speculate on the ability of borrowers to repay their debts.  They are taken with parameters in mind and so shocks to the system, like that spiking LIBOR, can put one end of the bargain under stress.

The Financial Times reports that US banks alone have $157 trillion in derivatives on their books, up 12% on the onset of the GFC and, for context, a figure more than twice global GDP.  Citigroup alone have $44 trillion prompting one analyst to remark:

“[Citi] seem to have forgotten the time when they were a buck a share,” alluding to the GFC trough in March 2009.

If there is one individual who knows firsthand the dangers in this space it is Tom Russo, chief legal officer of Lehman Brothers for 15 years, right up until they collapsed in September 2008.  He notes that when things got bad, counterparties simply refused to pay.  From FT:

“In ordinary times, he says, financial markets function like bee hives: everyone working together, performing the roles expected of them. But when things start to turn and panic begins to spread, people want nothing to do with anyone beyond their very closest associates. Everyone acts independently, and in their own interests. Or to put it another way, “bees become chimps”…… “When you owe a little bit of money you call your banker to pay it,” says Mr Russo. “When you owe a lot of money you call your lawyer to get out of it.”

Long term readers will know of Deutsche Bank’s infamous derivatives book (one of the largest in the world) and the trouble that bank went through in 2016.  Whilst it left the headlines for some time, its back, with the aforementioned credit spikes and the strengthening Euro causing it real pain with its shares falling 6% to their lowest since that strife in late 2016.  Most other major Euro banks are following it.

In such a tightly sprung, highly leveraged and highly correlated financial system the repercussions of just one big counterparty failing could be enormous.  Central banks rescued the GFC.  The big question is, do they have any ammunition left?