——— FINANCIAL POLICY FORUM ———
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Washington, D.C. 20036
Credit Loses Through Derivatives
New Data from the Office of the Comptroller of the Currency
Financial Policy Forum
December 29, 2004
The Office of the Comptroller of the Currency (OCC) recently released data on derivatives holdings at US commercial banks for the third quarter of 2004.
The report showed that the amount of outstanding derivatives on the books of U.S. commercial rose to $84 trillion at the end of the fourth quarter of 2004.
Of these derivatives holdings, measured by notional principal, $73 trillion were in interest rate derivatives such as over-the-counter (OTC) swaps, forward rate agreements and options as well as exchange traded futures and options.
This figure will prove very interesting when the fourth quarter data come out due to an apparent ‘excessive market pressure’ or manipulation attempt in the market for 5-year U.S. Treasury securities. A large buildup in positions in interest rate futures has accompanied a reported attempt by at least one firm to hold the 5-year note and keep it out of the repo market. As a result, the repo rate on the 5-year note is reported to be “on special” by 200 basis points. While large trader positions in the exchange traded positions are reported frequently to the CFTC and known by the relevant exchanges, the OTC positions are not reported in any detail, the aggregated figures are reported only quarterly and firms such as hedge funds do not report at all – making it much easier to build up a position without alerting regulators and other market participants. The fourth quarter data will not be published for approximately three months.
The amount of credit derivatives held by U.S. banks rose to $1.9 trillion – up from $1.5 trillion the previous quarter. This compares to a BIS report of global holdings of $4.5 trillion at mid-year 2004. Aside from measurement differences, U.S. banks are holding about a third of the global amount.
These derivatives holdings remain concentrated in the largest U.S. banks. The largest five banks hold 95% of the total for all 634 reporting banks, with the largest 25 banks holding 99% of all outstanding amounts. The largest dealer, JPMorgan, holds $43 trillion of the industry total of $84 trillion. The vast majority of these are used for trading purposes – i.e. speculation and market making – and only a tiny portion is used to hedge their loans and other assets.
The credit exposure to U.S. banks from these $84 trillion in derivatives rose to $3.9 trillion. Like the amounts outstanding, the credit exposure is also concentrated. As a result, some of the top banks have a very high credit exposure relative to their risk-based capital (tier 1 plus tier 2 which includes common and preferred stocks, subordinated debt, and loan loss reserves). At the extreme end, JPMorgan reports that credit exposure from derivatives is 800% of capital, while that for the top five banks averages 341% of capital. In comparison, the average of all 634 reporting banks is 4.5%. The exposure for the top banks has also grown sharply over time. At the end of 2001 the average credit exposure of the top five banks was 211% of capital – thus the current 341% figure represents an increase of over 50% in less than three years.
This rise in credit exposure has occurred despite the fact that they report a 84% reduction of their credit exposure due to legally enforceable netting arrangements (meaning primarily that the ISDA master trading agreement and its credit annex are assumed to be legally effective). Without the 84% reduction, credit exposure would be about seven times as high.
Although actual credit loses are usually small, except for years like 2001 when Enron collapsed or 1998-99 with bankruptcies and defaults in emerging markets, the first three quarters of 2004 show a sharp increase in write-offs compared to the first three quarters in 2002 and even 2003. Banks lost $250 million or a quarter billion dollars through the first three quarters alone.
Usually, trading profits on derivatives activity dwarfs these credit losses. However the trading profits (which include trading in the cash market as well as derivatives markets) are down for the last two quarters. This is primarily due to losses on interest rate swaps and other types of derivatives since profits on foreign exchange, commodities and equities are roughly holding even. For example, JPMorgan’s trading profits have fallen from 12.4% to 3.5% of revenue in the past year while Wachovia has actually generated trading losses in the past quarter.
A final and critical point about the OCC data is that the OCC does not date its quarterly reports and does not publish a schedule for their release. These are two key differences from almost all economic data collected and disseminated by the U.S. government. Derivatives markets have become a very important part of U.S. financial markets and information about them is critical for those making investment and consumption decisions in the U.S. economy. The data should also provide important information to policy makers about growing vulnerabilities or potential dangers to the financial system and the economy as a whole. For these reasons, it would be very productive to collect and distribute information on derivatives markets in a manner akin to information about securities markets, futures and options exchanges, and other spheres of finance and the economy.