Ghost Writers In the Sky

by Brian Pretti CFA, Contrary Investor. July 24, 2009

Just so happens the 1Q banking system derivatives report hit the tape a few weeks back. A very quick check in for a number of reasons important to our current circumstances. Yes, derivatives still remain quite the unreconciled macro US financial sector issue of leverage, but given the concentration of ownership of financial derivatives among the large US banks currently well ensconced in the government witness protection program, it’s not the magnitude of exposure most concerning at the moment. You may have seen that Mark Mobius recently mentioned he expects another financial sector panic at some point given the unresolved character of systemic US financial sector derivatives. His time frame was 5-7 years, which is basically an investment lifetime over which few should be holding their collective breath. Rather, the here and now issue as I see it is that banking system derivatives exposure is a tangential measure or corroboration point for US credit cycle growth, or lack thereof. And that’s really the key point this go around in 1Q. The total growth in US banking system notional derivatives in 1Q increased $1.6 trillion. That’s pocket change compared to historical experience of the last two years where average quarterly growth in exposure was $8.5 trillion in notional exposure. Moreover, we need to remember that prior to late last year, our wonderful friends at Goldman Sachs were not included in the official banking system body count, as is now the case. So we had a huge add to the numbers in terms of Goldman, and the nominal growth in notional exposure has still slowed to a near halt. What’s the bottom line here? The bottom line is the lack of growth in the derivatives complex is corroborating the fact that the US credit cycle remains sidelined. Deleveraging is the order of the day. The derivatives report is simply corroboration. And as I’ve proffered far too many times this decade, the US was running on a credit cycle in the prior up economic cycle experience, not a business cycle. In aggregate, it’s the credit cycle that would have been the forward fertilizer for any green shoots that have popped up as of late. The report is telling us the fertilizer bag is empty for now. Wither green shoots? (Pun clearly intended.)

Very quickly, please note that the 2009 growth rate detailed in the bottom clip of the chart above is annualized. If indeed the current character of derivatives activity in the banking system is maintained ahead as was the experience in 1Q, we’ll be looking at the lowest annual growth rate for derivatives exposure really on record. Does that tell us something about financial sector and credit cycle slowing, and change relative to the prior cycle? You bet it does.

Again, although the government has made it clear they will support the behemoth banks at all costs, I’d note that counter party risk in the greater banking system has moved to levels I never thought I’d see. Of course the inclusion of Goldman in these numbers as of 4Q of 2008 has prompted this change in the numbers, but as you can see below, close to 90% of macro banking system derivatives risk has been laid off to “counter parties”. Bilateral netting is the official term, but it represents offsetting derivatives transactions with third parties all with the intent of theoretical risk mitigation. First, there is no question that this netting is in part interwoven among the banks themselves – banks offsetting contracts with other banks. Although the data is not detailed in the report, it has to be the case that banking system exposure has also been heavily hedged with non-bank counter parties as well. AIG was a huge counter party, and that’s worked out oh so wonderfully well for US taxpayers, right? Of course the “taxpayers” at work at Goldman have benefited tremendously at the expense of remaining US taxpayers as far as AIG counter party risk is concerned. CIT even had exposure. Given the very fragile nature of what we are seeing throughout the financial sector globally, inclusive of the hedge community, etc., in no way is this supposed risk mitigation comforting. Have the banks really passed perhaps the most important stress test that lies directly below? Of course there is no way of knowing. And the Fed/Treasury/Administration are certainly intent on keeping it that way, now aren't they?

Certainly what transpired with the banks over the last few years in terms of residential mortgage exposure was almost a near death experience for many. But looking ahead, we still have the commercial real estate cycle as well as ongoing and meaningfully deteriorating consumer credit (cards) issues to work through. And all the while, derivatives exposure lies in the background. AIG is the poster child example of showing us that relying on financial risk mitigation is only as meaningful or strong as the financial integrity of the insurer, or counter party, on the other side of the trade. Point being, never has the banking system been more reliant on the integrity of bigger picture financial sector players on the other side of these bilateral netting agreements. And never has the financial sector as a whole been under greater credit cycle deleveraging pressure than we see today. In my mind, counter party risk issues today are a very meaningful watch point.

Really without need for comment, the largest bank players in the game are the usual suspects. Of course the current roster now includes the Goldman money machine. The “big four” (JPM, Goldman, Citi and BofA) are the derivatives exposure in the US banking system. For all intents and purposes, everyone else is a rounding error.

Finally, in 1Q 2009 banking system exposure to credit default swaps hit a modest new high. And although nominal global commodity prices have done their best imitation of Mr. Toad’s Wild Ride over the last year, the US banking system maintains meaningful exposure on this front for their clients and their prop desks.

Final comment. Stepping back and trying to look at the very big picture thematically, continuing to be aware of the dynamics of US financial sector derivatives exposure remains an important exercise for a key reason. Although it’s just my perception of the macro that is playing out, it is clear to me that the “fix” US financial authorities have chosen for the economy and the financial sector specifically is an attempted reflation as opposed to the alternative path that would be debt restructuring. In one sense, Japan in the early 1990’s chose the same path. Although holding interest rates at zero and embarking on quantitative easing for Japan were to be temporary measures, they have really become constants over close to the last decade at least. This is a direct real world experiential lesson the US authorities apparently have failed to heed. And given recent Japanese economic and inflation/deflation stats, it has bought Japan exactly nothing. The same medicine has been applied by Japan again and again, with exactly the same result - nothing in terms of true economic stimulative influence. Repeating the same actions and expecting a different outcome? Yes indeed, Einstein's definition of insanity. Will the fate of the US economy and financial sector be similar as we move ahead? Although the jury remains out, a number of very sane voices in the investment community are of the opinion that until true debt restructuring occurs, the US economy will not be able to get back on any type of an organic growth path. To be honest, I personally agree. Academically, and particularly in light of the Japanese experience, this argument is not to be dismissed lightly.

So circling back to the derivatives issue here is my big question to you. Does the US in aggregate have the flexibility to attempt some type of systemic debt restructuring, or does current derivatives exposure in the system preclude this as an option given the necessary “writeoffs/losses” that would have to be absorbed by those heavily exposed to financial derivatives themselves? I do not pose this question to be pessimistic. I’m simply trying to assess the true options and flexibility available to the US financial and economic system looking ahead. Considering an attempt at macro US debt restructuring, what would happen to the $16 trillion of notional credit default swap values on the books of the banks? How about interest rate derivatives that make up the bulk of banking system exposure? I wish I had specific and quantifiable answers to these questions, but no one does. All I do know is that Japan in a similar situation ignored the path of debt restructuring and followed the reflation script as the prescription for recovery. Even when it became clear the reflation path (ZIRP and QE) was unsuccessful they have never veered from that path to this day. In the clarity of hindsight that was clearly the wrong choice. The US in current circumstances has chosen the same reflationary path right down to following the script of ZIRP (zero interest rate policy) and quantitative easing, ignoring the debt restructuring option. And we are to expect a different result than has occurred in Japan? As I see it, the magnitude and focus of derivatives exposure in the US banking system is a “hidden” constraint on US flexibility in the current cycle. It has limited remediation choices for the financial authorities and perhaps predestined forward US economic outcomes to those similarly seen in Japan.

I sincerely hope I am wrong in this assessment or perceptual analysis, but I see derivatives exposure as a tourniquet around US systemic financial flexibility. For those waiting around for US financial sector debt restructuring initiatives, don’t hold your breath. For those expecting the US to wean itself off of ZIRP and QE any time soon, please practice the same breathing control suggestion – no holding your breath. The derivatives behemoth Mobius refers to is the hidden constraint around US systemic macro financial flexibility. Just don’t tell the oh so generous US taxpayers, okay? They just might start asking questions.

Brian Pretti

© 2009 Brian Pretti

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