Please don't ask me to explain what the hell a derivative is, but it sounds like bad news given the y2k context. It is also part of the puzzle that y2k-middle-of-the-road-ers' don' seem to get. When they predict a mild (but sudden) recession plus a manageable 25% - 30% drop in the markets, they don't seem to factor-in the knock-on effects this would have on derivatives markets and the institutions exposed to them. This ommission is quite understandable because derivatives are quite difficult to understand: even George Soros who has won and lost billions on derivatives has been quoted as saying that he doesn't fully understand what they are or how they work. Any how, the following article explains it all to some degree, and outlines what is a very serious factor for y2k -market-meltdown scenarios. (IMHO, y2k market meltdowns, on a greater scale than 1929, are guaranteed.)

Derivatives Exposure Report

By Steven J. Williams Updated: 11/14/98

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The Quarterly Derivatives Fact Sheet from the Office of the Comptroller of the Currency (OCC) is a collection of derivative activity information from all banks. Each bank must prepare a "Condition and Income" report from which the OCC gathers its data. The most recent report available is currently the 1998 Q2 report from which the data herein was obtained (the Q3 report should be available soon).

What is a derivative? The OCC glossary contains the following definition: a derivative is a "...financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof..."

Perhaps the most striking single piece of information in the report is the fact that the total amount of derivatives held by U.S. banks is $28,176,000,000,000 -- in case you did not count the zeroes, that's $28 Trillion!!

This staggering sum is comprised of $10 Trillion in futures and forwards, $11 trillion in swaps, and $7 Trillion in options. The rest is a fairly insignificant $129 Billion in credit derivatives. $20 Trillion is concentrated in interest rates and $8 Trillion is in foreign exchange derivatives.

The top 8 U.S. banks hold 95% ($26.6 Trillion) of all reported derivatives. These top banks include the following (with stock symbol): Chase (CMB) includes Chemical from merger, J.P.Morgan (JPM), Citibank (CCI), NationsBank (NB), Bankers Trust (BT), Bank of America (BAC), First Chicago (FCN), and Bank of New York (BNY).

When looking at the percentage of credit exposure to risk based capital, JPMorgan has exposure of 728%, Bankers Trust has 373%, Chase has 334%, Citibank has 194%, and First Chicago has 175%. The other big banks are exposed for less than 100% of their capital.

Up through Q2 (June 30, 1998), the banks have made money on their derivative positions, as follows: $1.4 Billion from foreign exchange and $930 Million from interest rates.

JPMorgan derives 23% of all of its revenue from trading derivatives compared to the next closest bank, Citibank which derives only 7% from its derivative trading.

To be up-front, not all of the $28 Trillion exposure is currently at risk. Actually, when looking at only interest rate and foreign exchange derivatives, only $11 Trillion is at risk with an expiration horizon of less than one year and another $11 Trillion exposure for a 1-5 year expiration horizon. Whew, that's a relief!

It should also be pointed out that only $109 Billion in derivatives is exposed for less than 1 year for equities (stock market). Commodities (including gold and precious metals) are only $71 Billion for less than one year to expiration.

The following table demonstrates the breakdown by category of risk exposure for the 8 banks with the highest derivative positions held. The columns have the following meanings: Assets is the total assets of each bank, Derivs is the total derivative exposure (all expirations), One Year is the total derivative exposure that expires in less than one year, Equity is the banks exposure to the stock markets, and 30% Corr is the amount of derivative loss if the stock markets suffer a 30% correction within one year.

Bank Assets Derivs One Yr Equity 30% Corr Chase 367B 8,299B 3,635B 7.8B -2.3B JPMorgan 281B 7,447B 2,487B 53.9B -16.2B Citicorp 331B 3,299B 2,067B 13.8B -4.1B NationsBk 308B 2,325B 331B 8.5B -2.5B Bk Trust 172B 2,203B 963B 17.8B -5.3B Bk Amer 264B 1,709B 781B 0.4B -0.1B 1st Chicago 120B 1,199B 469B 4.5B -1.3B Bk of NY 63B 264B 19B n/a n/a

One you can see, if Chase were to suffer a 10% loss in the derivative exposure which expires in less than one year, their entire asset base would be wiped out. For JPMorgan it would only take an 11% loss to wipe out their asset base.

For the banks exposure to only the stock markets, JPMorgan leads the pack. If stocks suffer a market correction of 30%, JPMorgan could stand to lose $16.2 Billion. And, that's only their equity derivative exposure with an expiration of less than one year. If the stock markets entered into a long-term bear market lasting 5 years or more, JPMorgan's exposure would be $76 Billion and a 30% correction over that time could result in a loss of $22.8 Billion.

It appears to me that several of these banks have been in a difficult situation for the past few quarters. Many of these banks participated in investing in the LTCM hedge fund, in addition to directly holding derivatives, which magnified their exposure to market fluctuations. The near collapse of LTCM would have been a disaster for many of these banks. First, the forced liquidation of the derivatives held by LTCM would have certainly caused the markets to fall even further. Second, the leveraged exposure these banks had to the markets directly though their own derivative positions, would certainly have added to their losses. Third, with a portion of derivatives expiring on October 16, 1998, it is no wonder that the FED stepped in to assist in a multi-participation bank bailout of LTCM and announced an emergency rate reduction on the day before many derivatives were set to expire.

In prior articles, I mentioned that JPMorgan holds controlling interest in the stock of the Federal Reserve Bank, and the FED has been instrumental in making market-moving announcements over the past few quarters -- it does not take much effort to suggest that ulterior motives may have been at work to influence the FED's decisions.

The main problem currently being faced by the FED and the banks is what to do next. If interest rates are lowered again, it may cause rate-sensitive derivatives to generate extreme losses for the banks. Chase has $2.2 Trillion in derivative exposure that expires in less than one year, JPMorgan has $1.6 Trillion exposure.

In addition, adjusting interest rates will also affect currency exchange rates. Chase and Citibank each hold $1.4 Trillion of foreign currency derivatives, and JPMorgan holds $829 Billion, all expiring in less than one year.

If you have ever wanted to witness an ultra-high stakes situation where the players were literally "between a rock and a hard place", this has got to be the very best example that you will ever see. Unfortunately, none of the information will be made public (if at all) until well after the major events have taken place.

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http://www.geocities.com/~CyclePro/Charts/SP500/Outlook.htm

--------- p.s. Could a resident geek be kind enough to format the chart in this article? Ta.

-- humptydumpty (no.6@thevillage.com), April 20, 1999

Answers

Derivatives are financial contracts which are based on underlying currencies, bonds or securities. Typically they are used to ameliorate risk. They are engaged in by private entities such as banks and corporations, usually across international boundaries. They are completely unregulated or supervised.

A simple derivative is ..

Bank 'A' buyes bonds in country 'b'. This exposes bank 'A' to a currency risk. Bank 'A' buyes a contract with bank 'C' in country 'b' which provides that if country 'b's currency takes a negative turn in relationship to the bonds, then bank 'C' will pay bank 'A' the difference. If the currency becomes favorable to bank 'A' then bank 'A' will pay bank 'C' the difference. This supposedly buys bank 'A' safety in the bonds.

But no one knows what everyone else has bet on and its possible for alot of people to bet the same way causing the ship to capsize at a slight provocation.

This is in the process of happen right now and alot of corps and banks are in a world of hurt because of these 'bets'. Just not making any headlines right now.

-- David (C.D@I.N), April 20, 1999.

HOUSABOUT a link to this article?? I lost mine and would like to get back to see if the table has been updated now. Chuck PS This is not a new article.

-- chuck, a Night Driver (rienzoo@en.com), April 20, 1999.

Hi Chuck, yes it's an old article, and here is the link to it. What do you think about this topic Chuck-A-N-D?

http://www.geocities.com/~CyclePro/Charts/SP500-Articles/DerivExpo.htm

-- humptydumpty (no.6@thevillage.com), April 20, 1999.