This page has been archived and commenting is disabled.

The Next Step in the Bank Implosion Cycle???

Submitted by Reggie Middleton on 10/28/2009 02:49 -0400

Of the many issues that I have been warning about concerning banks,
their balance sheets and the risks that they take, one of the (and
there are a few) most underappreciated is the currency risk of the
"mother of all carry trades". See Roubini Not Alone in Fearing Dollar Carry Trade and Roubini Sees `Huge' Asset Bubbles Growing in `Mother of All Carry Trades'.

Investors
worldwide are borrowing dollars to buy assets including equities and
commodities, fueling “huge” bubbles that may spark another financial
crisis, said New York University professor Nouriel Roubini.

“We
have the mother of all carry trades,” Roubini, who predicted the
banking crisis that spurred more than $1.6 trillion of asset writedowns
and credit losses at financial companies worldwide since 2007, said via
satellite to a conference in Cape Town, South Africa. “Everybody’s
playing the same game and this game is becoming dangerous.”

The
dollar has dropped 12 percent in the past year against a basket of six
major currencies as the Federal Reserve, led by Chairman Ben S.
Bernanke, cut interest rates to near zero in an effort to lift the U.S.
economy out of its worst recession since the 1930s. Roubini said the
dollar will eventually “bottom out” as the Fed raises borrowing costs
and withdraws stimulus measures including purchases of government debt.
That may force investors to reverse carry trades and “rush to the
exit,” he said.

“The risk is that we are
planting the seeds of the next financial crisis,” said Roubini,
chairman of New York-based research and advisory service Roubini Global
Economics. “This asset bubble is totally inconsistent with a weaker
recovery of economic and financial fundamentals.”

As
has been the case at least twice in the past, I am in agreement with
the man. The amount of bubbliciousness, overvaluation and risk in the
market is outrageous, particularly considering the fact that we haven't
even come close to deflating the bubble from earlier this year and last
year! Even more alarming is some of the largest banks in the world, and
some of the most respected (and disrespected) banks are heavily
leveraged into this trade one way or the other. The alleged swap hedges
that these guys allegedly have will be put to the test, and put to the
test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ),
you cannot truly hedge multi-billion risks in a closed circle of only 4
counterparties, all of whom are in the same businesses taking the same
risks.

Click to expand!

See
the following for a backgrounder on my opinion before we move on to the
risks of currency volatility and interest rate swaps in the "Too Big To
Fail, but Too Big to Let Survive Intact" club:

- JPM Report (Subscription-only) Final - Professional
- JPM Forensic Report (Subscription-only) Final- Retail

So, How are Banks Entangled in the Mother of All Carry Trades?

Trading revenues for U.S Commercial banks have witnessed robust growth
since 4Q08 on back of higher (although of late declining) bid-ask
spreads and fewer write-downs on investment portfolios. According to
the Office of the Comptroller of the Currency, commercial banks'
reported trading revenues rose to a record $5.2 bn in 2Q09, which is
extreme (to say the least) compared to $1.6 bn in 2Q08 and average of
$802 mn in past 8 quarters.

High dependency on Forex and interest rate contracts

Continued growth in trading revenues on back of growth in overall
derivative contracts, (especially for interest rate and foreign
exchange contracts) has raised doubt on the sustainability of revenues
over hear at the BoomBustBlog analyst lab. According to the Office of
the Comptroller of the Currency, notional amount of derivatives
contracts of U.S Commercial banks grew at a CAGR of 20.5% to $203
trillion by 2Q-09 from $87.9 trillion in 2004 with interest rate
contracts and foreign exchange contracts comprising a substantial 84.5%
and 7.5% of total notional value of derivatives, respectively. Interest
rate contracts have grown at a CAGR of 20.1% to $171.9 trillion between
4Q-04 to 2Q-09 while Forex contracts have grown at a CAGR of 13.4% to
$15.2 trillion between 4Q-04 to 2Q-09.

In terms of absolute dollar exposure, JP Morgan has the largest
exposure towards both Interest rate and Forex contracts with notional
value of interest rate contracts at $64.6 trillion and Forex contracts
at $6.2 trillion exposing itself to volatile changes in both interest
rates and currency movements (non-subscribers should reference An Independent Look into JP Morgan, while subscribers should reference File Icon JPM Report (Subscription-only) Final - Professional, and JPM Forensic Report (Subscription-only) Final- Retail).
However, Goldman Sachs with interest rate contracts to total assets at
318.x and Forex contracts to total assets at 11.2x has the largest
relative exposure (see Goldman Sachs Q2 2009 Pre-announcement opinion 2009-07-13 00:08:57 920.92 Kb, Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb, Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb,).
As subscribers can see from the afore-linked analysis, Goldman is
trading at an extreme premium from a risk adjusted book value
perspective.

As a result of a surge in interest rate and Forex contracts, dependency
on revenues from these products has increased substantially and has in
turn been a source of considerable volatility to total revenues. As of
2Q-09 combined trading revenues (cash and off balance sheet exposure)
from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or
9.5% of the total revenues while the same for GS and BAC (subscribers,
see BAC Swap exposure_011009 2009-10-15 01:02:21 279.76 Kb)
stood at $(196) million and $433 million, respectively. As can be seen,
Goldman's trading teams are not nearly as infallible as urban myth
makes them out to be.

Although JP Morgan's exposure to interest rate contracts has declined
to $64.5 trillion as of 2Q09 from $75.2 trillion as of 3Q07, trading
revenues from Interest rate contracts (cash and off balance sheet
position) have witnessed a significant volatility spike and have
increased marginally to $1,512 in 2Q09 compared with $1,496 in 3Q07.
Although JPM's Forex exposure has decreased from its peak of $8.2
trillion in 3Q08, at $3.2 trillion in 2Q09 the exposure is still is
higher than 3Q07 levels. Even for Bank of America and Citi , the
revenues from Interest rate and forex products have been volatile
despite a moderate reduction in overall exposure. With top 5 banks
having about 97% market share of the total banking industry notional
amounts as of June 30, 2009, the revenues from trading
activities for these banks are practically guaranteed to be highly
volatile in the event of significant market disruption - a disruption
aptly described by the esteemed Professor Roubini as a rush to the exit
in the "Mother of All Carry Trades" as the largest macro experiment in
the history of this country starts to unwind, or even if the
participants in this carry trade think it is about to start to unwind.

The table below shows the trend in trading revenues from Interest rate and Forex positions for top banks in U.S.

Click to enlarge...

Banks exposure to interest rate and foreign exchange contracts

With volatility
in currency markets exploding to astounding levels (with average
EUR-USD volatility of 16.5% over the past year (September 2008-09)
compared to 8.9% over the previous year), commercial and
investment banks trading revenues are expected to remain highly
unpredictable. This, coupled with huge Forex and Interest rate
derivative exposure for major commercial banks, could trigger a wave of
losses in the event of significant market disruptions - or a race to
the exit door of this speculative carry trade. Additionally
most of these Forex and Interest rate contracts are over-the-contract
(OTC) contracts with 96.2% of total derivative contracts being traded
as OTC. This means no central clearing, no standardization in
contracts, the potential for extreme opacity in pricing, diversity in
valuation as well as a dearth of liquidity when it is most needed - at
the time when everyone is looking to exit. Goldman Sachs has
the largest OTC traded contracts with 98.5% of its derivative contracts
traded over the counter. With the 5 largest banks representing 97% of
the total banking industry notional amount of derivatives and most of
these contracts being traded off exchange, the effectiveness of
derivatives as a hedging instrument raises serious questions since most
of these banks are counterparty to one another in one very small, very
tight circle (see the free article, "As the markets climb on top of one big, incestuous pool of concentrated risk... ").

The table below compares interest rate contracts and foreign exchange contracts for JPM, GS, Citi, BAC and WFC.

JP Morgan has the largest exposure in terms of notional value with
$64,604 trillion of notional value of interest rate contracts and
$6,977 trillion of notional value of foreign exchange contracts. In
terms of actual risk exposure measured by gross derivative exposure
before netting of counterparties, JP Morgan with $1,798 bn of gross
derivative receivable, or 21.7x of tangible equity, has the largest
gross derivative risk exposure followed by Bank of America ($1,760 bn,
or 18.1x). Bank of America with $1,393 bn of gross derivatives relating
to interest rate has the highest exposure towards interest rate
sensitivity while JP Morgan with $154 bn of Foreign exchange contracts
has the highest exposure from currency volatility. We have explored
this in forensic detail for subscribers, and have offered a free
preview for visitors to the blog: (JPM Public Excerpt of Forensic Analysis Subscription 2009-09-18 00:56:22 488.64 Kb), which is free to download, and File Icon JPM Report (Subscription-only) Final - Professional, or JPM Forensic Report (Subscription-only) Final- Retail as well as a free blog article on BAC off balance sheet exposure If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - BAC).

Subscribers, see WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb, ~ WFC Off Balance Sheet Exposure 2009-10-19 04:25:53 258.77 Kb ~ WFC Investment Note 22 May 09 - Retail 2009-05-27 01:55:50 554.15 Kb ~ WFC Investment Note 22 May 09 - Pro 2009-05-27 01:56:54 853.53 Kb ~ Wells Fargo ABS Inventory 2008-08-30 06:40:27 798.22 Kb to expound on our opinions of Wells Fargo, below.

Subscribers, see MS Simulated Government Stress Test 2009-05-05 11:36:25 2.49 Mb and MS Stess Test Model Assumptions and Stress Test Valuation 2009-04-22 07:55:17 339.99 Kb

Factors contributing to record trading revenues in 1H09

In 1H09 trading revenues were positively impacted by strong activity in
interest-rate and money-market products, steep yield curves and
declining short-term rates which usually help banks generate
mark-to-market gains on their investment portfolio. As per the OCC
2Q2009 report, one of the major factors that contributed to record
trading revenues was the changes in the value of derivatives payables
and receivables. During 2Q09, following results of the stress tests for
large banks, credit spreads had narrowed down sharply. The net effect
of these changes to the fair values of derivatives payables and
receivables, which contribute to trading revenues, had a material
impact during 2Q09. In addition, the banks also benefited from wider
margins (bid-ask spreads) due to lower competition and reduced risk
appetite amongst existing players.

Are record Fixed Income Currency and Commodities (FICC) revenues sustainable in the long run......?

The record trading revenues reported by commercial banks were on back
of low investment write-downs and higher bid ask spread. After
reporting record trading revenues of $9.8 bn in 1Q09, the revenues from
this segment is under pressure. In 2Q09, the trading revenues declined
to $5.2 bn and further the declining trend continued in 3Q09 as well,
with banks reporting further deterioration in the trading revenues
growth q-o-q. For example, Goldman Sachs' (GS) trading and principal
investment revenues declined by 7.0% q-o-q to $10.0 bn in 3Q09 as
compared to $10.8 bn in 2Q09, while Bank of Americas' trading revenues
fell 5.6% q-o-q to $1.8 bn.

If we look at the actual fundamentals for the previous quarters,
specifically from Q42008 through 3Q2009, we could hardly witness any
significant improvement or sign of economic recovery. Unemployment
levels continue to rise, consumer spending is dismal, retail sales are
declining and bankruptcies across industries are still being witnessed
while CRE losses have yet to peak and we feel residential real estate
losses have reached a faux peak through a combination of governmental
bubble blowing and seasonality. Foreclosures and shadow inventory are
building at a record pace while interest rates are as low as they can
effectively get, and the main value drivers for consumption of
residential real estate: availability of credit, wealth, employment,
and income, have been beaten severely and are still on the downturn at
a time when supply is STILL being introduced into the market at a
dizzying pace in the form of foreclosures and soon to be finished
construction projects tailing off from the end of the credit boom.
Eighteen to 24 month construction cycles are dumping 2007 projects in
our laps right about now, see - "Who are ya gonna believe, the pundits or your lying eyes?"and Who are you going to believe, the pundits or your lying eyes, part 2 . Here, a picture is worth a thousand words...

There ain't nuthin like building thousands of extra condo and apartment
rental units next to empty condo/rental to be lots, as condo/rental
prices plunge amid a glut of condo/rental supply - all funded by banks
leveraging FDIC guaranteed consumer monies!

We may (or may not) have seen the worse, but chances are there is a lot
of pain is still left. This should be witnessed in terms of higher
investment write downs (than in past couple of quarters) in the coming
periods and lower trading revenues which spiralled up off temporary
highly favorable, yet quite unsustainable factors. The bid-ask spreads
(which currently are at high levels by historical standards) have been
beginning to show signs of narrowing of late. This should pull down the
phenomenal growth we have witnessed in recent quarters in the trading
revenues of said banking institutions.

- advertisements -

Fri, 10/30/2009 - 08:16 | 114904 HayeksConscience

The system is corrupt and broken. It needs to be brought down and recreated in a form that looks like real capitalism (sans Fed).

What are the chances of some financial arsonist putting a well placed bomb in the pile of spaghetti known as the derivatives market and bringing the whole thing down on top of the giant squid and all its spawn.

Thu, 10/29/2009 - 00:12 | 113706 juliawong

GS and JPM are gaining from the other big (TBTF?) banks via the interest rates derivatives as they are "tipped" off by Fed (they own the Fed) as to the where the interest rate trend is heading. Meanwhile, the likes of Citibank are paying thru their noses for their losing bets as the other end(counterparties) of the same interest rate derivatives back by FDIC.

Fed+JPM+GS are holding the US taxpayer as ATM cash machine so long as TBTF's losses are "socialized" and Fed+JPM+GS's profits are "privatized" thru these interest rate derivatives bets. That's what's REALLY going on.

Wed, 10/28/2009 - 16:13 | 113300 time123

Excellent article. very informative and with lots of detailed graphs. Yes, the dollar has been replacing the Yen as the carry trade instrument of choice due to low interest rates in the U.S.

Whenever short covering on dollar shorts occurs, we will be experiencing the phenomenon of market corrections aross all assets that have been bought with it (through borrows dollars.) Today's trading action is just an example of more to come.

time123

P.S. I get my timing signals at http://inverics.com

Wed, 10/28/2009 - 12:57 | 113049 Anonymous

Can't you just write a book and post a link to it. This post was way too long.
Valid points... but perhaps some venting thrown in. Keepem short and to the point!

Wed, 10/28/2009 - 12:33 | 113025 Anonymous

Why is it we can only see the world in terms of our own neighborhood?

It's a big world. The EU has a combined GDP larger than the US, but very disparate. BRIC and the rest are all dependent on trade.

Mr. Buffet used the term "Economic Pearl Harbor" not "Civil War" or "Internal Strife". No one questions why. Everyone seems to accept that the enemy from within, GS, MS, C are the subject of his retort, and yet he bankrolled it! Since when do you fight your enemy by fronting $5 billion at 10%?

Make no mistake, this is war. Like in chess, a good strategy does not come at no cost, nor is it readily evident how tactics tie to strategy and how an intentional retreat can weaken the resolve of the enemy and draw them into an ambush.

Wed, 10/28/2009 - 12:28 | 113021 Cursive

Reggie,

Do you have any theories on what would reverse the carry trade? A reversal based on technical trading analysis. Really bad earnings? Implosion of some bank counterparty? Some exogenous event like invasion of Iran?

Wed, 10/28/2009 - 12:17 | 112985 dnarby

So let me get this straight:

JPM has $64.6 trillion dollars of interest rate swap exposure.

If the Fed raises interest rates, they are screwed, and whoever they sold them to is as well (because JPM can't cover that bet, and neither can the Fed). So as long as rates stay low long enough for the 'muddle through' to work, everything is hunky-dory.

But if the rest of the world raises interest rates, and the Fed does not, that calls the viability of the USD into question, which leads to a currency crisis in the USD.

...So if the 'muddle through' doesn't work, everything financial is totally F*CKED.

Wed, 10/28/2009 - 11:35 | 112956 Anonymous

jim willie has been on this story for at least 3 months so it is nice to get some confirmation from an expert.....

what are the banks' exposures in term of the dollar? are they long or short the dollar? or have they hedged it so well that either direction will work?

Wed, 10/28/2009 - 11:32 | 112953 Anonymous

awesome stuff reggie

Wed, 10/28/2009 - 10:41 | 112901 BobPaulson

Why would the banks limit their risk exposure when they know all the down side of the risk will be backstopped by you and I?

This is like asking North Korea not to make nuclear arms when their nuclear arms are the one thing that has saved them from invasion.

This is psychology 101. Not tough stuff, sortof like training your dog.

en.wikipedia.org/wiki/B._F._Skinner

Wed, 10/28/2009 - 12:16 | 113006 dnarby

The NK analogy is a poor one. The main thing that keeps NK from being invaded is that they are NK.

And as far as backstopping things is concerned... How do you backstop the equivalent 150% of the world's GDP?

Thu, 10/29/2009 - 09:54 | 113978 lookma

How do you backstop the equivalent 150% of the world's GDP?

Currency devaluation.

Wed, 10/28/2009 - 10:33 | 112885 agrotera

Thank you Reggie--your post is like a video tape of a premonition, with plenty of details!

Wed, 10/28/2009 - 10:19 | 112862 Anonymous

You have great insight Reggie! I am not in the finance field and the number crunching goes over my head a bit. One thing I have wondered as I have seen record fixed income revenue over the last few quarters is this.

How much of fixed incomes profit is coming from accounting changes. Removal of mark to market accounting as well as banks simply moving their assets from tradeable securities to ones they plan on holding to maturity (sorry if that is not the right jargon). Is there a way to quantify these gains?

Anyways, thanks.

Wed, 10/28/2009 - 10:06 | 112847 Anonymous

So, the $640 Trillion dollar question is: how long can the Banks keep running in mid-air, like Wile E. Coyote? Especially if their cash position is now deteriorating, and this rate of deterioration is increasing, like some have claimed?

This quarter? Next quarter? I'm thinking gravity will start taking effect next year some time, but I really don't know. I'd be interested in your opinion, Reggie.

Wed, 10/28/2009 - 19:52 | 113552 Marvin T Martian

wile e. coyete is an apt analogy.

according to my indicators, we are currently @ 38 seconds:

http://www.youtube.com/watch?v=hz65AOjabtM&feature=related

Wed, 10/28/2009 - 10:35 | 112890 Anonymous

"how long can the Banks keep running in mid-air, like Wile E. Coyote?"

The Batman suit offers no protection against colliding with that cliff wall...

Wed, 10/28/2009 - 19:09 | 113499 bpj

Probably have the ACME super printer printing money.

Wed, 10/28/2009 - 09:56 | 112837 Anonymous

Reggie:

This is great stuff. Could I prevail upon you to explain a few more things?

1) What are the risk capital requirements for these derivative exposures under Basel II? In other words, how much capital do these banks need to hold to support these notional derivative exposures?

2) If world Governments required more capital to be held against these positions, what impact would it have on bank capital positions?

Thanks in advance,

Spanishmoon

Wed, 10/28/2009 - 09:31 | 112807 tip e. canoe

funny that you should show that particular condo development.

not only is it smack dab at the foot of the Manhattan Bridge AND right next to the Brooklyn Queens Expressway AND on one of the most heavily congested boulevards in Brooklyn, but if you look closely, you'll see it's being built fully surrounding a Public Storage facility AND right next to another large storage facility...not to mention the Mickey D's next door.

genius.

Wed, 10/28/2009 - 08:51 | 112768 Leo Kolivakis

Reggie,

Wow, you sure pack it in one post! Well done but let me take it a step further. There is an abundance of liquidity out there coming from banks, insurance companies, pension funds, sovereign funds, hedge funds, private equity funds, and retail investors who are all chasing higher yields. Risk assets have been bid up all around the world, especially in countries with commodity linked currencies and shares.

What are banks hoping for? Two things. They want the Fed and other central banks to keep rates at historic lows for as long as possible and they hope that global growth will surprise to the upside. That's why they're taking leveraged bets via derivatives.They also hope to make money in mergers & acquisitions if the economy improves.

Are they risking another financial meltdown? Sure they are, but the mentality is let me make as much money as possible and go retire on some island with my millions and let the suckers (taxpayers) clean up the mess.

Read Andrew Ross Sorkin's new book, Too Big To Fail, and you'll understand what capitalism really is - it's all about the financial oligarchs who control banks and politicians. Main Street can bend over and grab their ankles. They have no say in the new financial capitalism.