A Step by Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually Have, and How It Could All Go Boom!

Reggie Middleton's picture

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bingocat's picture


The title, "A Step By Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually Have, and How It Could All Go Boom" is probably overstating what you have presented here.

Your derivs exposure "analysis" is the same as last time when at least one other "pro" commentator posted some analysis of your analysis (in the commentary to your post about JPM's aiding and abetting insider trading on 10b5-1 sales plans), and the conclusion was that actual low-grade counterparty derivatives exposure (which is surely collateralized under their CSAs) was far lower than sub-IG lending exposure to corporates (which is often collateralized too) and lower than your numbers suggest.

As I wrote there, the derivatives PROBLEM is not that there are 5 banks. They have very active CVA desks to cancel out those issues. The "correlation problem" is that the tens of thousands of corporate clients of JPM and other banks are usually all in the same direction. And if they all suffer at the same time, JPM will go on seizing collateral or unwinding trades according to ISDA/CSA documentation.

What this means, as it did with Lehman, is that while banks are well-protected, senior unsecured creditors (bondholders, etc) are going to have much lower recovery ratios in any bankruptcy than most people model/expect. The substantial increase in collateralized derivatives exposure for banks is actually a boon. It allows banks to demand more collateral/margin almost constantly, turning their business into secured lending while unsecured lenders (non-collateralized loans or bonds) are much more like contingent equity - if TSHTF, they own equity, not debt, because the collateral seizure mechanism has a downward spiral effect on the asset prices which represent both the collateral available to be posted and the assets available for recovery post default event.

Once again in reply to one of your posts citing the Lehman experience, I am obliged to remind you that Lehman did NOT go down because of its derivatives exposure. It went down because a) real-time liquidity provision on a NON-collateralized basis dried up, and collateral values were disputed, and b) the funding ladder Lehman ran was a colossal risk management screwup. It was bad risk management plain and simple. One thing remarkable about the Lehman bankruptcy was how little effect it had on global bank counterparties (the 5 big banks, among others) where there was sufficient collateral posted according to the CSA. As noted above, the problem was that senior unsecured creditors of Lehman got hosed. This points out how much better it is to have derivative exposure to banks than to have notional credit exposure (by buying their bonds or lending them money), and it illustrates the importance of understanding collateral and collateral risk management systems.

What I want to see is analysis which tells me what would happen if one separated out the entire derivatives business, and all its hedges (both internal and external) into a separate box, and then analyzed the factor sensitivities of that business to interest rate curve risk, equity prices, real estate prices, etc, THAT would be interesting. My bet is that such analysis would be impossible to do on the basis of public data, and until one can see the portfolio, and shock it, speculating on their and other banks actual risk management practices regarding exposure and collateral management is almost useless.

Until then, the REAL risk is sudden market "appreciation" of an imminent onset of something like a Great Depression II and the impact that has on everyone at the same time. That is not a derivatives risk. That is an "everything risk."

AUD's picture


"The creditor banks had helped to finance the boom by 'confining' themselves to a most 'liquid' asset, to credits granted to other (foreign) first class banks. What could look more liquid than a balance with an A-1 bank? But what guarantee did the creditor have that the debtor bank would keep liquid in its turn?"

Melchior Palyi, 1936

tony bonn's picture

"Over the three years since I have been publishing BoomBustBlog, I have amassed what many consider a remarkable track record, having called nearly every major market crash and large financial/real estate/bank collapse over said time period."

and in his spare time he invented the internet....

actually this was a good article refuting a lame spook who wrote here last week or so claiming that we needed to embrace financial innovation defending derivatives on the very basis refuted here...

a grey swan would be sufficient to cause a catastrophe. a white swan with a black speck would be enough....and yet this crooked mess is to be embraced....my fat ass...

Wolf in the Wilds's picture

Hi Reggie,


As much as I would like the banks to do down, I do believe derivatives exposure is not necessarily the axe that chops off their heads.  I have been in the industry for a long time and derivative counterparty exposure is something I am very familiar with.  I do agree counterparty risk is a major issue, only to the point that counterparty risk transforms into market risk when the counterparty defaults.  The actual exposure between counterparties at the point of default is capped to a large extent by the collateral agreements between them.  HOWEVER, if the counterparty defaults, the bank may have to reestablish the trades that they had with the counterparty.  This is the act that leads to massive market dislocations, which may or may not result in losses. 

As to whether there is enough collateral out there for US$80trn notional of derivatives, I do believe there is given that most derivatives valuation are a lot less than the notional.

Of course, this is premise on the CSA being above general liquidation/bankruptcy laws (we saw that they were in the case of Lehman's demise), where the collateral is not subject to general distribution in the event of a default. 

The main RISK has always been REPLACEMENT risk.  And the resulting dislocation can cause major economic shocks. 

anonnn's picture

Reggie, awesome perceptions and analysis.

Brooksley Born remarked that she could discern no rationale for the very real Greenspan/Summers/Rubin et al drive to suppress regulation.

As a minor observer, I can only postulate wildly what may be afoot. 

But... since the 16th century [!][English] Hakluyts began their data collection of all global resources, thru modern Anglo-American moves in "resource wars", there is surely s/g afoot!

 The only 4 BigOil giants are Anglo-Amer:  R D Shell/ BP/ Exxon/ Chevron; and along with the short tail of cheap petroleum production, are surely a piece of the drive to dominate resource allocation.

I submit the financial "mess" was caused, somehow, in concert with the urge to dominate, albeit perhaps not going as planned. And the English know well how to operate via proxies....they are, curiously, a small island nation...and coinkydinky like Japan, do/did project enormous influence.

Global resilience, to withstand unplanned disruption, is at an historic low...an enabler of  Black Swans.

ptolemy_newit's picture


Please post your research and analysis that support your posts, I am looking for balance before.

well purgatory is waiting for you!


Coldfire's picture

You don't hedge the risk, you transform it. Excellent point, Reggie. Ex.cell.ent. Generally speaking there is - in fact - zero hedge. Netting under ISDA has been shown to work in a bankruptcy (ie., post-hoc) situation for a single firm. But the assumption that total risk can be timely netted in a systemic crisis is breathtakingly facile, mendacious, or both. The regulatory derivatives scheme is a Babel Tower of complexity, a sweat act of subjectivity, whose price signal failures will be its undoing. As this scheme goes, so goes JPM.


jm's picture

But the assumption that total risk can be timely netted in a systemic crisis is breathtakingly facile, mendacious, or both.


I'll take the other side of this. We really don't know how things will turn, no?

We are entering a world of exchange trade instead of OTC, which implies no Lehman-type "I'm not paying to a defaulted counterparty" events.  So past precedent may be useless.  I ask:  why SHOULD settlement be so hard given a clearinghouse?  You lose your reserve fund and ALL your collateral if you try to cheat the house.

While we're on the subject, collateral exists and you aren't factoring it into your adjectives.  I know that at least some hedge funds have to post 100% on NOTIONAL.  I don't know for sure about other parties, but collateral offers a non-trivial moment of clarity re: timely netting.  

Maybe one should worry about the predicates: liquidity management, risk exposures, and model (conceptual and emotional) failure. 

Coldfire's picture

You are right, the posting of collateral should be factored in. And clearinghouse settlement would fundamentally change the picture for the better, but only for new issuance. The problem of post-hoc clearinghouse migration of existing instruments is intractable.

RockyRacoon's picture

Unbelievable.  How does this house of cards stand?  The next destabilization will be a nightmare scenario come true.

Excellent work, Reggie.  Thank you for your work.

Fred Hayek's picture


I've seen video clips in which Chris Whalen says, pretty categorically, that JP was the one bank that he knew of which correctly transferred the note in the mortgage backed securities it created.  Is there a chance that JP remains standing as others fall simply by having done a little paperwork efficiently?

Reggie Middleton's picture

I can say, without a doubt that WaMu had one of the more inefficient and error prone systems. JPM bought WaMu, so even if JPM was that good, unless they straightened the WaMu mess out very quickly, well then...

bullandbearwise's picture

A lot of this risk is mitigated by zero-bound interest rates. Which is why it is impossible for rates to move up again in our lifetime...

jkruffin's picture

The easiest way to bust this fraud once and for all, collapse these scam institutions, and put the market back in proper order is simple.  Everyone in this country, and around the world stop paying mortgages.   Plain and simple.  If they try to foreclose, have ammo and barrel in hand with your nieghbors on your property.

Neither the FED, ECB, BOJ, or any other country central bank is going to step inside that realm.  There was a reason Lehman and Bear were sacrificed.  They had the lowest exposure and the cover-up was implemented.  Wells Fargo might want to watch out, because they might be the next Bear/Lehman victim.

But like I said, the only solution is fight fire with fire, and stop paying these scam bankers.  The house of cards will collapse so fast if you blink you might miss the crash.

junkhand's picture

TBTF going down=401ks going down=pension funds going=states going down=cities going down=euro banks going down



dream on.  we are just brushing the surface of this unwinding.  it is like the cold war.  only most folks never even heard about this buildup of weaponry.


Buck Johnson's picture

Good job reggie, good job.  Many people don't understand what is at stake, and if they did they would be running these people and their enablers out of the country.  This game that is being played can not go on for much longer and the markets outside the US and the financial institutions know it.  The western banking system is insolvent, they have played a game of leveraging debt upon debt upon debt and causing it fiscal responsibility. 

AUD's picture

An interesting question is what risks to its own credit would the Fed see if it 'settled' these liabilities?

Going on the results of last time, I'd have to say that the Fed would have no qualms about taking on these debts.

After all, by any objective measure the Fed is illiquid, insolvent &/or bankrupt & has been for years. Yet the USD is still 'money'. So much so that foreign holdings of US debt is at record highs.

jkruffin's picture

"So much so that foreign holdings of US debt is at record highs."

The FED is the 2nd largest holder of US debt, and soon to be the largest. Those like China that hold large amounts of US debt are going to front run the FED out the door since Bernanke likes to telegraph everything he does to the world.  Then the bond bubble bursts.  Americans once again become rape victims in the process.

Bob's picture

When the shit does hit the fan, and those 5 big fat intelligent boys run for the exit in a nearly 100% correlated movement of allegedly diversified and hedged (netted) assets, not all of them are going to fit through the door!!!

Reggie, I'm being lazy here, but tell me this.  If this is truly the circle jerk you say, would it not suggest that if TSHF, then the Big 5 will go down, but they'll take virtually all of the CDO risk with them? 

A lot of paper money lost, to be sure, but it would seem like a relatively small price to pay to effectively dissolve the absurd universe of CDO's while at the same time getting rid of the systemic cancer of the TBTF's?


sgt_doom's picture

Sweet, Reggie my man, very sweet.

And this is exactly why the Treasury Dept.'s Office of Debt Management, and the Usual Suspects, don't want to ban naked swaps, while the Euros do.





Vorpal1's picture

So much info and hedge beef!! RM - Can you explain why the 2B2F (not porn) big banks on your list shouldn't "drop to Zero" over a short enough time period? And why does being intelligent have anything to do with money?

gwar5's picture

The derivatives bubble is the scariest to me. It's an unregulated high wire act with no net.

In 1998 the LTCM meltdown came just 8 weeks after Brooksley Borne was kicked out as head of the CFTC, under duress of congress, due to Robert Rubin, Larry Summers, Timothy Geithner and Alan Greenspan ferociously ganging up on her.

They were extremely fearful of any regulation, or light, shed upon the dark derivative markets.



TheMonetaryRed's picture

Reggie, is the problem the rating of JPM's exposure or the fact that the falling rating may reveal a statistical "hump" of bad credits hidden in aggregate numbers?

tallystick's picture

Reggie, what's your take on hybrid CDOs?  How much real collateral got intermixed with derivative nonsense in these cash/synthetic hybrid monstrosities?



Eternal Student's picture

This is superlative work, once again, Reggie. Thank you.

There's one thing that I don't understand though. If the big banks have a total of around $200 Trillion in derivatives, and the world-wide market is around $650 Trillion which are known (according to the BIS), where's the other $450 Trillion?

StychoKiller's picture

When you touch a lit match to a pile of gunpowder, does it matter where?  Once the first domino falls, we'll find out the answer to your question rather quickly.  Will it matter if, let's say France, owes everyone $200Trillion vs $100Trillion?

Eternal Student's picture

You raise a valid analogy, and yes, I do believe it matters where. To use your gunpowder analogy, if you don't see the lit match, then the explosion does seem instantaneous. If you do see the lit match, you've got some time to make final preparations and anticipate; as opposed to being under "shock and awe".

While these collapses happen quickly, they are not instanteous. Not even the crash of 1929 was. It played out over days, and if you got out on that last Friday when things were looking up, you may have gotten out with profit. Again, we saw that back in 2008 (heck, I saved a bunch of money back then).

This is why I'd like to be looking for the lit match.

sgt_doom's picture

Some in play over the various exchanges, others parked at various international public-private partnerships, at various financial institutions and services:

Macquarie Group, Credit Suisse FB, Deutsche Bank, Barclays, UBS, held by all those opaqe global hedge funds, sovereign funds, funds of funds, LBO funds, pension funds......

Eternal Student's picture

Thanks. And yes, but what I am wondering is more along the lines of how it's broken down? I.e. is JPM the biggest elephant on the planet, or is there a bigger one which is more exposed? For example, Credit Suisse has a well documented (to put it politely) reputation of playing fast and loose.

Or even a breakdown by continent? For example, the impact of Greek bonds on this House of Cards. Or perhaps even Ireland giving their bank bondholders a haircut?

I've suspected that the bigger risk is really from the countries on the central European periphery, while everyone is more focused on U.S. Real Estate. I was wondering if anyone anywhere has really looked at this and published some numbers?

ConfederateH's picture

Reggie, I haven't seen you send a broadside into the Swiss banks lately.  What's your take on their current situation?

Jasper M's picture


   Give In to your Hate, and Join Me, on the Dark Side!

Chemba's picture

How did western civilization ever develop without the blinding insights of Reggie Middleton?

By the way, calculations using notional value are highly misleading.  The credit exposure on a financial derivative is not the notional value.  Since Reggie is the smartest man in the world he must understand that, but perhaps the hyperbole inherent in the "analysis" is helpful in selling subscriptions.

Panafrican Funktron Robot's picture

Interesting that he was humble enough to explicitly state that other people were smarter than he was, but you still had to throw the bomb anyways.

Regarding your comment on notional vs. net, seems pretty obvious from, you know, reading the actual article, that he was pointing out how small the net loss had to be to completely nuke these banks.  I would suggest taking off the blinders and actually reading it, most of us are not in the Reggie fanboy club and I'm assuming he would want that club to have zero members, but you come off as sounding pretty retarded when you post shit like this.

Reggie Middleton's picture

Maybe Chemba failed to read the whole article, referencing counter party risks, fair value, netting and other issues. Why bother reading the posts if you don't like them.

Chemba's picture

Your analysis includes a sensitivity of tangible equity to losses as % of notional value, so, regardless of what you "say", you are explicitly assuming that the credit risk is equal to notional value.  As an aside, you have no way of understanding (from the outside) how exposure to counter-parties net and cancel.

It's not a question of "not liking" your posts.  I am simply pointing out that the analysis has flaws and is "sensationalist".

You seem a smart guy, as a marketer certainly.  Were we back in the hey-day late 1990s I'd recommend you for a sell-side position at a bulge bracket bank.  But if your insights were as powerful and investable as you claim there would be no reason to sell them.  Instead, you'd simply rack up the returns on your own (and others) capital.  Sell siders do analysis and sell it, buy-siders invest.

Reggie Middleton's picture

Again, you fail to read what it is you comment upon. The notional value argument is thoroughly addressed. I have no problem with you pointing out weakneses, but the article has to be read first. You obviously didn't read it.

As for whether I act upon my own advice, that is all I do. Whether I fit "your" idea of a sell side or buy side agent is highly irrelevant. I'm an independent hence if I want to sell my opinion or research, then I will do so without having to fit into traditional labels.

Not everybody wants to run money, particularly other people's.

sgt_doom's picture

"As an aside, you have no way of understanding (from the outside) how exposure to counter-parties net and cancel."

And neither do those on the inside, douchebag!


TheGreatPonzi's picture

With all the sovereign debt stories going on, people quite forgot that derivatives were actually the worst danger. Good reminder.

DaveyJones's picture

Mutual Assured Destruction: and to think we were afraid of nukes

anonnn's picture

from Charles Dickens "Little Dorrit":

person who can't pay gets another person who can't pay to guarantee that he can pay. Like a person with two wooden legs getting another person with two wooden legs to guarantee that he has got two natural legs. It don't make either of them able to do a walking-match. 

 [any color is a format error]

gousnavy's picture

Taleb's "Black Swan (an unforseeable and unpredicatble event)" is the financial equivalent of DEAF CON 5. Reggie's analysis drops it to less than 5. Right on Reggie. Keep trying to turn the nuclear financial clock back from 12 AM.

Ancona's picture


World governments won't let these behemoths get broken up for a very simple reason; they know that many of the banks assets are either imaginary [marked to unicorn] or so badly compromised that a break-up would expose just how bankrupt these institutions really are, collapsing world banking overnight.


The risks to world commerce are just too huge to shut these monsters down. All commerce would cease nearly immediately if the ten largest banks were placed in to a resolution trust situation.


As usual, your insightful information is too much for a mere engineer to digest all at once, so I'll save most of it for later, when I can kick back in the 'ol barcolounger and digest it properly.


Thanks for your contributions Reggie. [And thank God you don't work for "them"]

The Axe's picture

Hey,,Reggie..haven't seen you post on PPD (Reggie = Large PPD hater) seems like there "might be" a PE bid of $60 for PPD, its at a 52 weekly high. Now 10 times book value is high for a private equity firm, and I don't believe management...but $63 is 63 dollars... 

Reggie Middleton's picture

Yes, 63 dollars is still 63 dollars just as a ponzi scheme is still a ponzzi scheme. Bubbled stock prices don't cause me to waiver in my opinion. Didn't BSC sell for 180 dollars 6 months or so before their ponzi collapsed?

web bot's picture

I'm not even smart enough to comment... but nice work.


hooligan2009's picture

The quality of your work just keeps getting better!

Had this conversation about counterparty risk a year or so ago with JM.

The key points I had were that the net P/L per derivative position were largely collateralised via Credit Support Annexes (CSA's) to ISDA's. Hence the players think that counterparty risk is entirely mitigated by daily collateral posting (and substitutable according to terms in the CSA).

I maintained that within the (pick a number) $700tn derivatives market there was insufficient collateral in existence to cover the existing net p/l of all derivatives and that gap risk was the event that would prick the bubble. JM thought that most positions were 1-3 year interest rate swaps and weren’t collateralised. The industry went through a huge net off exercise post Lehman’s in March 2009 I think.

Many CSA’s specify haircuts in proportion to the credit rating of the collateral pledged. I don’t know but guess that the highly rated collateral used to secure p/l on derivatives is now doubtful. The ratings agencies are silent for “foreclosure gate” and are back in the firing line for also not verifying the content of mortgage pools.

We now have to wait for the rating agencies to follow the leading analysts such as you; once more they are reactive, not proactive.

This is not to say that the credit ratings of the banks themselves aren’t suspect (Fitch has moved a little I think), but the mortgage market is suspect. It can only be a whisker before investors simply pull out because the market is broken (fraudulently based).

The other risk (aside from collateral risk) that I fretted about was duration risk. That is “mind the gap” spike in Treasury bond yields. As soon as it becomes apparent that we have a normal 2+2 GDP and CPI economy (may not happen and we are now Japan, but let’s say it does), the yield curve will gap upwards to reflect a 4% Fed Fund rate and a positive curve with the ten year at 4.5% from 2.5%ish now.

The p/l impact on $700tn for a move up for every 1% increase in Treasury yields with an overall weighted duration of, say 6 years is in the trillions, drop this number for the hell of it by 75% and you still get a $1tn collateral call.

The biggest counterparty risk is the Fed though, since it is the lender of last resort to the banks.


jm's picture

Hey guys.  Nice post Reggie.

I guess we must disagree about the notional stuff... I think there is a huge amount of double counting in there, because the big swinging dicks offset out of the money positions.  The beauty of a swap is due to how easy they are to deploy in this way.

I think based on the data we have, which is admittedly incomplete, net is more informative because it kicks out the double counting.  Such as it is.

A real problem with IRS is just like single name CDS... jump to default.  Bernanke plays his stupid game too far and you have a problem he can't print out of.  If LIBOR blows, then there will be less chance to reduce out of the money IRS exposure... nobody will take the other side of the trade.  But you know, if that happens, one's 401k is so irrelevant.

Irishmans Curse's picture

'many have even went so far as to call me “intelligent”.'