The looming quadrillion dollar derivatives tsunami part 1
On March 10, the US Silicon Valley Bank (SVB) collapsed and was taken over by federal regulators. SVB was the 16th largest bank in the country and its bankruptcy was the second largest in U.S. history, following Washington Mutual in 2008. Despite its size, SVB was not a “systemically important financial institution” (SIFI) as defined in the Dodd-Frank Act, which requires insolvent SIFIs to “bail in” the money of their creditors to recapitalize themselves.
Technically, the cut-off for SIFIs is $250 billion in assets. However, the reason they are called “systemically important” is not their asset size but the fact that their failure could bring down the whole financial system. That designation comes chiefly from their exposure to derivatives, the global casino that is so highly interconnected that it is a “house of cards.” If one pulls out one card, the whole house collapses. SVB held $27.7 billion in derivatives, no small sum, but it is only 0.05% of the $55,387 billion ($55.387 trillion) that is held by JP Morgan, the largest US derivatives bank.
SVB could be the canary in the coal mine foreshadowing the fate of other over-extended banks, but its collapse is not the sort of “systemic risk” predicted to trigger “contagion.” As reported by CNN: Despite initial panic on Wall Street, analysts said that SVB’s collapse is unlikely to set off the kind of domino effect that gripped the banking industry during the financial crisis.
“The system is as well-capitalized and liquid as it has ever been,” Moody’s chief economist Mark Zandi said. “The banks now in trouble are much too small to be a meaningful threat to the broader system.”
No later than Monday morning, all of the insured depositors will have full access to their insured deposits, according to the FDIC. It will pay uninsured depositors an “advance dividend within the next week.”
The FDIC, Federal Reserve and U.S. Treasury have now agreed on an interim fix that will the subject of another article. Meanwhile, this column focuses on derivatives and is a follow-up to my 23 Feb 2023 column on the “bail in” provisions of the 2010 Dodd Frank Act, which eliminated taxpayer bailouts by requiring any insolvent SIFIs to recapitalize themselves with the funds of their creditors. “Creditors” are defined to include depositors, but deposits under $250,000 are protected by FDIC insurance. However, the FDIC fund is sufficient to cover only about 2% of the $9.6 trillion in U.S. insured deposits. A nationwide crisis triggering bank runs across the country, as occured in the early 1930s, would wipe out the fund. Today, some financial pundits are predicting a crisis of that magnitude in the quadrillion dollar-plus derivatives market, due to rapidly rising interest rates. This column looks at how likely that crisis is and what can be done either to prevent it or dodge out of the way.
“Financial Weapons of Mass Destruction”
In 2002, mega-investor Warren Buffett wrote that derivatives were “financial weapons of mass destruction.” At that time, their total “notional” value (the value of the underlying assets from which the “derivatives” were “derived”) was estimated at $56 trillion. Investopedia reported in May 2022 that the derivatives bubble had reached an estimated $600 trillion according to the BIS (Bank for International Settlements), and that the total is often estimated at over $1 quadrillion. No person knows for sure, because most of the trades are done privately.
As of the third quarter of 2022, according to the “Quarterly Report on Bank Trading and Derivatives Activities” of the Office of the Comptroller of the Currency (the federal bank regulator), a total of 1,211 insured US national and state commercial banks and savings associations held derivatives, but 88.6% of these were concentrated in only four large banks: J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), followed by Wells Fargo ($12.2 trillion).
Unlike in 2008-09, when the big derivative concerns were mortgage-backed securities and credit default swaps, today the largest and riskiest category is interest rate products.
The original purpose of derivatives was to help farmers and other producers manage the risks of any dramatic changes occurring in the markets for raw materials. But in recent times they have exploded into powerful vehicles for leveraged speculation (borrowing to gamble). In their basic form, derivatives are just bets – a giant casino in which players hedge against a variety of changes in market conditions (for example exchange rates, defaults, interest rates, etc.). They are sold as insurance against risk, which is passed off to the counter-party to the bet. But the risk is still there, and if the counter-party can’t pay, both parties lose. In “systemically important” situations, the government winds up footing the bill.
Like at a race track, players can bet although they have no interest in the underlying asset (the horse). This has allowed derivative bets to grow to several times global GDP and has added another element of risk: if you don’t own the barn on which you are betting, the temptation is there to burn down the barn to get the insurance. The financial entities taking these bets typically hedge by betting both ways, and they are highly interconnected. If the counter-parties don’t get paid, then they can’t pay their own counter-parties, and the whole system can go down very quickly, a systemic risk that is called “the domino effect.”
That is why insolvent SIFIs had to be bailed out in the Global Financial Crisis (GFC) of 2007-09, first with $700 billion of taxpayer money and then by the Federal Reserve with “quantitative easing.” Financial derivatives were at the heart of that crisis. Lehman Brothers was one of the derivative entities with bets across the system. So was insurance company AIG, which managed to survive due to a whopping $182 billion bailout from US Treasury; but Lehman was considered too weakly collateralized to salvage. It went down, and the Great Recession followed.
Risks Hidden in the Shadows
Derivatives are largely a creation of the “shadow banking” system, a group of financial intermediaries that facilitates the creation of credit globally but whose members are not subject to regulatory oversight. The shadow banking system also includes unregulated activities by regulated institutions. It includes the repo market, which evolved as a sort of pawn shop for large institutional investors with more than $250,000 to deposit. The repo market is a safe place for these lenders, including pension funds and US Treasury, to park their money and earn a bit of interest. But its safety is insured not by the FDIC but by sound collateral posted by the borrowers, preferably in the form of federal securities.
As explained by Prof. Gary Gorton:
This banking system (the “shadow” or “parallel” banking system) repo based on securitization is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created.
While it is true that banks create the money they lend simply by writing loans into the accounts of their borrowers, they still need liquidity to clear withdrawals; and for that they largely rely on the repo market, which has a daily turnover just in the US of over $1 trillion. British financial commentator Alasdair MacLeod observes that the derivatives market was built on cheap repo credit. But interest rates have shot up and credit is no longer cheap, even for financial institutions.
According to a December 2022 report by the BIS, $80 trillion in foreign exchange derivatives that are off-balance sheet (documented only in the footnotes of bank reports) are about to reset (roll over at higher interest rates). Commentator George Gammon discussed the threat this poses in a podcast called, “BIS Warns of 2023 Black Swan A Derivatives Time Bomb.”
Also currently in the news is Credit Suisse, a giant Swiss derivatives bank that was hit with an $88 billion run on its deposits by large institutional investors late in 2022. It was bailed out by the Swiss National Bank through swap lines with the US Federal Reserve at 3.33% interest.
This article appeared in Ellen Brown’s blog site Web of Debt, and was first posted on ScheerPost.
Ellen Brown is an attorney, chair of the Public Banking Institute, and is author of thirteen books.
Source: Web of Debt blog, 13 March 2023