"The Trillion Dollar Ticking Time Bomb of Derivatives"

by Graham Summers

"At "Gains, Pains, & Capital" I’ve been warning about the Trillion Dollar Ticking Time Bomb of derivatives for months now. As a brief recap, let’s consider the following:

• The current notional value of derivatives on US commercial banks’ balance sheets is $203 trillion.
• 97% of these ($196 trillion) sit on FIVE banks’ balance sheets (more on this shortly)
• If even 1% of this $203 trillion is “at risk” … you’re talking about $2 TRILLION in at risk bets made in the derivatives market
•If 10% of that 1% end badly, you’re talking about $200 billion in losses
• Total equity at the five banks is $737 billion. So if you assume that only 1% of derivatives are “at risk” (odds are it’s more) and 10% of that at risk money is lost, you’ve wiped out nearly 1/3 of the banks’ equity.
• If 2% of derivatives are “at risk” and 10% of those bets go bad, you’ve wiped out $400 billion or nearly HALF of the banks’ equity.

• If 4% of derivatives are “at risk” and 10% of those bets go bad, you’ve wiped out ALL OF THEIR EQUITY and they go to ZERO.

Remember, I’m only accounting for derivatives here… I’m not even including ON BALANCE sheet risks, mortgage backed securities, and all the other junk floating around. Suffice to say derivatives are HUGE time bomb waiting to go off. And what could trigger them? Interest rates.

Of the $200+ trillion in derivatives on US banks’ balance sheets, 85% are based on interest rates. For this reason, I cannot take ANY of the Fed’s mumblings about raising interest rates seriously AT ALL. Remember %$firstname$%, most if not ALL of the bailout money has gone to US banks in order to help them raise capital. So why would the Fed make a move that could potentially destroy these firms’ equity (essentially undoing all of its previous efforts)?

However, at this point, the Fed may not have a choice... as I showed in yesterday’s issue, the bond market is DEMANDING higher yields from US debt. Put another way, US debt holders are unwilling to continue funding our profligate spending without getting paid more to do it… I can’t say I blame them, since the prospect of collecting a 3% yield to own a currency that’s lost 15% in the last six months isn’t too appealing. But if yields rise this could blow up the derivatives market (remember 85% of derivatives are related to interest rates). So the question remains:

WHICH BANKS ARE SITTING IN THE DERIVATIVES MINE FIELD?

Click image for large size.

I want to be clear here. The above chart MAY not be as bad as it looks. Remember, NOT ALL notional value of derivatives are at risk. For instance, only 1% of the above numbers might actually be REAL money at risk. The issue however, is that NO ONE knows how much money is at risk here. No one. But considering:

The derivatives market is TOTALLY unregulated… the nightmare that has occurred due to instruments that were allegedly regulated (mortgage backed securities, etc.)… EVERY attempt to increase transparency or accounting standards at the banks has been met with threats of financial Armageddon…

It’s very difficult NOT to be freaked out by the above numbers. Personally, I sure hope that less than 0.0001% of that stuff is “at risk.” I hope bankers were more careful with interest-rate based derivatives than they were with mortgage-backed securities. I hope… But I doubt it."

- http://gainspainscapital.com