Davos and Goliath
by Brian Pretti CFA, Contrary Investor. February 16, 2007
To suggest that the always-growing financial derivatives complex has been the focal point of relatively intense debate over the last decade or so is one huge understatement. On one side of the issue stand the practitioners (those reaping huge fees, of course) claiming that derivatives have changed the financial market landscape for the better as their growing use has helped achieve the nirvana state of accelerated financial risk distribution. Academically, the greater the distribution of financial risk, the lower the chances of macro systemic risk. As you know, Sir Greenspan can be counted on this side of the sentiment ledger. On the other side of the debate stand those such as Buffet who either calmly claim that the interrelationships of risk are not well understood and ultimately present real and meaningful risk, or it’s the ever fun loving members of the hard core bearish underground suggesting a derivatives related end of the world as we know it is probably just around the corner. To see who's ultimately going to be the fortune telling victor in this great debate, we only need to stick around to find out. But so far, it’s been one long wait, as the financial derivatives mushroom cloud only grows larger.
Interestingly, financial derivatives became the focal point of controversy this year at the Davos confab -- Davos, of course, being the annual watering hole of some of the world's most important movers and shakers, and those who are the world's most important mover and shaker wannabe's. From the real world of central bankers and foreign government officials came words expressing warnings regarding the need to understand risk in the derivatives complex, which implicitly they believe is not happening. Zhu Min, Bank of China VP, chimed in, "You can easily get liquidity from the market every second for anything. We really don't know what the risks are." Jean-Claude Trichet, Euro Central Bank President, suggested, "Investors may not be accurately assessing risk." Montek Singh Ahluwalia, deputy chief of India's planning commission, said "Derivatives demand is a problem because people don't have much experience with the instruments in declining markets."
Luckily, on hand to set these officials that deal in real world outcomes straight on the matter of the explosive derivates growth as of late was one Thomas Russo, vice chairman of Lehman Brothers Holdings, Inc. "Risk is spread out in the financial services industry now much greater than ever before. You have very sophisticated people in credit, very sophisticated people in risk management. Not to say there aren't going to be mistakes, there are always going to be mistakes. There are people who will make bad loans -- that's just part of the game. But I think the sophistication today is keeping up with the complexity of the instruments." Thank heavens for voices like Russo's, correct? Regardless of the fact that Lehman profits from derivatives growth in a very big way, I'm sure that had absolutely nothing to do with the reassuring tone of his comments.
Trust me, I'm not going to turn this discussion into some ranting and raving diatribe about derivatives and risk. Why? The opacity of disclosure in this neck of the financial market woods leaves few facts with which to generate sound analysis or commentary. As you probably know, over 90% of the derivatives held in the US banking system are OTC. In other words, there is no listed market for these vehicles as they are customized to client requirements. But I hope it’s helpful to quickly review what factual information is available. Again, not to question the potential dark side fallout, but rather to question whether the real economy and global financial markets "need" the type of current growth we've been experiencing in financial derivates simply to continue functioning as we've recently come to expect. Because although it’s no secret that the Fed can and does create liquidity in the broader system, the derivatives markets clearly underpin credit and systemic liquidity creation well above and beyond Fed sponsorship. If you believe the macro credit cycle is of crucial importance to economic and financial market outcomes ahead, as I do, then monitoring the character of the derivatives complex to the best of our ability is also a must do exercise. Will there be any insightful and wildly illuminating answers in this discussion? No. Just perspectives. I simply hope that what's most important longer term is asking the right questions when it comes to derivates vehicles. Let's get right to it.
Neither for right or for wrong, we live in a world of financial securitization. This has been a major theme for well over a decade now. And as securitization as a concept and theme has grown, so too has it helped spawn an environment of excessive liquidity. This is exactly why looking at the derivatives data is so important in that it gives us a sense for both magnitude and ongoing growth. In terms of the greater credit cycle, the need to continually grow at faster rates is paramount. For without this we risk entering an environment of liquidity contracting on a rate of change basis. And that would be death to ongoing asset inflation, to say nothing of some pretty bad unintended consequences in terms of financial/derivatives markets. Will we ultimately experience a big problem in the greater derivatives markets at some point? It's probably a good bet. We've been there before if you can remember back to LTCM. But when and how big a potential problem is unknown. No sense in guessing. But what is important, especially in the current data, is recognizing and remembering just how fast risk needs to expand to keep the credit cycle moving ever forward. The data below really says it all.
Let's start with the most recent data from the keepers of the global numbers - the BIS (the Bank for International Settlements). Below is the most recent data since 1999. Why 1999? As you know, it has really been in the post US equity bubble environment where the credit cycle has really turned up the juice. As you can see, the BIS data covers half-year periods. For the latest data ended 1H 06, the prior six month growth in worldwide OTC notional derivatives outstanding was a little in excess of $72 trillion, standing at $370 trillion as of 6/30/06, up from $298 trillion at 2005 year end. For a bit of perspective, total planet Earth did not have $72 trillion in total derivatives outstanding eight years ago, and now we're growing by that total amount in six months. Incomprehensible. The chief cause of growth in the most recent period was credit derivatives as well as the old standby, interest rate related derivatives vehicles. Again, hard to believe we're seeing this type of growth. Is the global credit cycle in its supernova stage at this point?
The one and only place I've found were we get some type of true dollar at risk cash estimates for derivatives, as opposed to notional values, is in the BIS report. As is clear above, these folks are estimating that real cash exposure at risk in this market is $10 trillion as of 2Q 2006 period end. Given that the US banking system, and really about five individual US banks, account for a third of everything you see above, we can roughly estimate that the cash at risk numbers for these US banks specifically approximates maybe $3.3 trillion. Hardly an inconsequential number. Do the stockholders of JPM, BAC, and C (collectively 89% of total US banking system exposure) actually realize this?
So below is what has me shaking my head a good bit at the moment. Have a look. And get this, I didn't annualize the latest six month data in the chart below. If I had, we'd be looking at close to 50% annualized growth. Off the charts, to be more accurate. We'll just have to see what the second half of 2006 data brings when reported.
What I've done here is have an every six-month sequential growth rate look at the BIS global derivatives data. As you can see, there is no six-month period where we've seen this type of recent growth in worldwide OTC derivatives. Up 24% in six months, and this is on top of a huge notional outstanding number to begin with ($298 trillion). The virtual exponential acceleration is unmistakable. Is this what needs to happen just to keep the global economy and financial markets moving forward? Or is this indicative of truly runaway hyper speculation in global financial/credit markets? Or both? I can only imagine where this leads ahead, but I'm not so sure I want to. I simply can't fathom how this set of circumstances can again accelerate from here, but we'll soon find out where it all leads.
So there we have the global data. Next up in terms of public information is the data from the US banking system. In the first three quarters of last year, US banking system exposure to financial derivatives increased just shy of $25 trillion in notional outstandings. As you might be able to make out in the chart, nine months of growth in derivatives exposure last year was equal to the entirety of US banking system derivatives outstanding in 1997. The current pace of notional growth is simply eye popping.
But notional growth only tells part of the story. Much like total global OTC growth, the annualized rate of change in US banking system derivatives outstanding accelerated quite meaningfully through 3Q of last year. Is it that the derivatives markets are simply immune to the law of large numbers? Annualized growth through 3Q leaves 2006 as the third largest growth year for increased banking system derivatives exposure in a decade and a half. Wow! I would not have believed growth like this could have happened on such an already large base of exposure. A derivatives/credit/liquidity cycle on steroids? If not, then what is this?
I'll leave you with two last questions of ultimate importance to the "sophisticated people in credit and risk management," as Lehman's Russo calls them. In my mind, THE singular question of importance in the derivative complex is that of counterparty risk. In very simple terms, your ability to service the eventual outcome of a derivatives contract either depends on a counter party with which you've entered into an offsetting agreement, or your own equity. Seamless functioning of the derivatives world is much like a daisy chain, with each connection of daisy's dependent on the strength of the daisy preceding it. These days counter parties are everyone from other large money center banks to your friendly local neighborhood hedge fund. So the first issue in derivates complex complacency as it grows to what truly are gargantuan proportions is that counter parties to derivatives transactions will always and everywhere be solvent. Can we really count on that? Statistical odds would argue otherwise.
Finally, what you see below is what's known as bilateral netting. In other words, the supposed percentage of exposure the US banks, as an example, have laid off in offsetting counter party transactions to their own derivates books. Of course the obvious message is that the ability to continually lay off risk as notional values of contracts outstanding mushroom sure as heck seems to have hit a top end ceiling right here. We've been in the mid-80%'s for quite some time. This essentially means that as total system notional values and actual cash exposure grows, in absolute terms the banks are taking on much more direct cash risk. After all, 85% of a dollar is a bit different than 85% of $2, now isn't it. And it just so happens that US banking system notional derivatives exposure has doubled since this number first crossed the low 80% level in late 2002.
Again, the key point to be taken from the current data is the dramatic acceleration in growth and risk exposure both globally and in the US banking system specifically. Remember, this all feeds back into the credit cycle and underpins even higher levels of credit/liquidity expansion. Here's what may seem a crazy question for you. Which entity has a greater influence on liquidity creation domestically these days, the Fed or the derivatives markets? Although I could be wrong, I believe it’s the latter. And the exclamation point on this is the recent period rate of growth in both domestic and global financial derivatives activities. Off the charts hardly does justice to the characterization.
From the Davos financial and economic love fest, one very cogent comment regarding the derivatives complex came from Howard Davies, former head of the Financial Services Authority. "We all know that the reality of the financial markets is that risk is being parceled up and paced around. But international regulatory architecture is still organized as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age." IF there were ever a global problem in the derivatives complex, which authority would be in-charge, if you will? Which would take responsibility for the problem and take the leading role in remediation? Why are these questions important? Today, we live in a world of MCGCF – mouse click global capital flows. This is no longer your father's (or mother's) global financial system anymore. Not by a long shot. And so at Davos this year we have real world decision makers such as those mentioned above at least seeming to sound the need for some type of meaningful assessment and understanding of risk in terms of the recent explosive growth in global financial derivatives. Alternatively we have voices from Wall Street suggesting these worrywarts "just relax." Come to think of it, where've we heard that before? Oh yeah, wasn't this the tagline of a Schwab advertisement during the initial downleg of the equity bear early this decade? That advice worked out well, didn't it?
© 2007 Brian Pretti