Interest Rate Roundup

Thursday, September 28, 2006

Derivatives extravaganza -- $119 TRILLION!

I guess I should be jaded by now, and just ignore the numbers. But every quarter, I can't help but peruse the Office of the Comptroller of the Currency's (OCC) latest report on derivatives activity. It's not exactly beach reading. But it is, frankly, astounding to see some of the figures in these documents. The highlights of the Q2 report:

* The notional amount of outstanding derivatives held by U.S. commercial banks jumped 8% between the first and second quarter to ... drum roll please ... $119 trillion. That's also up 24% YOY. Just in case your curious, global Gross Domestic Product in 2004 was $41.4 trillion, according to the World Bank.

* Now as you may or may not know, notional value is NOT the same as the amount at risk that banks have. In OCC jargon: "The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. The credit risk in a derivative contract is a function of a number of variables, such as whether counterparties exchange notional principal, the volatility of the underlying market factors interest rate, currency, commodity, equity or corporate reference entity) used as the basis for determining contract payments, the maturity and liquidity of contracts, and the creditworthiness of the counterparties."

* So to determine "real" exposure, you want to look at various credit risk measures that allow for netting of winning and losing bets between institutions, and other compensating factors. Problem is, skyrocketing overall contract value is also pushing up "total credit exposure" -- it climbed to $1.4 trillion in Q2 from $1.31 trillion in Q1. Another measure of risk is lower. Called "Netted Current Credit Exposure," it was up $10 billion to $199 billion in Q2.

All in all, the OCC has lots of soothing language about why the gigantic growth in derivatives outstanding is not a big deal ... how the "real" possible losses are very small in relation to bank capital levels ... how complex modeling of "Value at Risk" shows that there isn't REALLY much risk of loss, etc., etc.

But like they say in war, no battle plan actually survives contact with the enemy. Even if all the reassurances are correct, and the derivatives extravaganza isn't a big deal, the RISK that it will BECOME a big deal with some black swan, unplanned event occurring down the road rises with every trillion dollars' worth of exposure you add in the system. Just some food for thought on this fine autumn day.


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